A Grueling Hike

Story Highlights:

• The MSCI World has pulled back five of the past six weeks.
• Steep declines like this tend to be more consistent with corrections than bear markets, which typically begin more slowly.
• Continued jitters over PIIGS and the end of QE2 may be weighing on stocks today, but these issues have been widely discussed for some time.
• The market may stay choppy awhile, but that’s normal in any bull market.

Seasoned hikers know no path leads straight to the summit: There are always ridges, valleys and sometimes grueling switchbacks on the way. It’s often the same with stocks. No bull market is a straight-line stroll to the top—flat periods, zig zags, pullbacks and corrections of -10% to -20% are all to be expected. And after falling five of the last six weeks, though the MSCI World pullback hasn’t yet hit official correction territory, it has some of the primary characteristics—a steep, sudden reversal.

Bear markets, by contrast, often start with a whimper, not a bang. They don’t usually announce themselves with sharp volatility the way corrections do. Instead, they often grind slowly down in the initial stages. Sharp downside volatility tends to come in the final stages of a bear market.

What’s more, corrections are primarily fueled by sentiment, not deteriorating fundamentals. Sentiment shifts can cause wild volatility in the very near term—like over a few weeks or months. But what drives stocks up or down over the course of 12 to even 24 months is sentiment catching up with underappreciated reality. No bull market period is pristine, and negatives do exist now. However, the negatives we currently see are those that have been widely discussed for some time.

One such issue is the continued ECB and German debate over the specifics of a second Greek bailout. Though the eurozone lacks a permanent framework for sovereign debt rehabilitation, one is in the works—as laborious as the process has been. (Hardly unexpected when asking 17 nations to agree to anything.) Meanwhile, some of the EMU’s more troubled members seem to be moving in the right direction. Italy and Spain have held successful debt auctions recently—yields have jumped a bit, but demand has been more than sufficient. Greece remains the weakest PIIGS member—and a thorn in the process—but the existence of the EFSF has effectively bought the eurozone time until mid-2013. Whatever shakes out, there’s ample financing already available to back Greece, and any serious eurozone woes are a 2013-and-beyond problem.

Meanwhile, on the homefront, the pending end of QE2 has some worried US economic growth will wane. But QE2’s June end was announced when the program started, robbing it of any surprise potential. Moreover, people frequently give QE2 too much credit for the continued expansion, discounting how healthy the economy was before QE2 started—not just GDP, but a cornucopia of indicators. Hence, it’s likely continued growth since has much more to do with the economy’s inherent strength. After all, most of QE2’s extra juice is idling at the Fed as bank reserves—not being lent or spent.

Still, six weeks or so of persistent declines can feel agonizing—corrections often do, even though they’re miniscule compared to many investors’ time horizons. But with no material, previously unappreciated negatives developing—at least that we can see now—the prudent course is to grit one’s teeth and wait out what is likely a typical correction (if it gets that official moniker). That doesn’t mean stocks won’t stay in this narrow trading range awhile longer—we think it likely 2011 returns are muted overall, and continued choppiness may test even the most patient investors.