Buying the Sell-Off

Well, here we go again. Futures were down big this morning, China’s stock market was down close to 9%, and it’s not looking good for U.S. markets in the early going.

There is blood in the street…

China appears to be in a full-on panic. High levels of margin and equally high levels of uncertainty about China’s economic outlook are a nasty double-whammy. Commodities-based economies are getting devastated.

Still, the most remarkable thing about this sell-off is the speed at which it’s happening.

Last Monday, the Dow Industrials closed at 17,545. Today, we’ll be lucky to close above 15,900.

That’s 1,645 points in five days — darn near a 10% correction. And the scary thing is that there’s no sign the selling is slowing down.

10% Correction

10% is the benchmark for corrections. I don’t know why that is. 10% is an awfully random number. But we can at least use it as a starting point to see what the heck is going to happen next…

Since the S&P 500 was started in 1957, that index has dropped 5% on 48 different occasions. 17 times out of those 48 drops, the S&P 500 went on to fall 10%. That’s where we are now. (And you should note that it’s less than a 50/50 bet that the S&P 500 continues to fall from 5% down to 10%.)

Now, of the 17 times the S&P 500 put in a 10% correction, it went on to fall 20% nine times. If history is any kind of guide, it’s basically a 50/50 bet on what the S&P 500 will do next.

A full 20% correction would take the S&P 500 down to ~1,700 (thanks to thereformedbroker.com for those stats). We haven’t seen that level since October of 2013.

I gotta tell you, I don’t much like the thought that the decision to buy at these levels comes down to a coin flip. That’s not what I call a strategy.

So what we do now?

Fundamental vs. Technical

One thing that should help is this: Market sell-offs usually begin as technical events, not as fundamental events.

What does that mean? A technical event is one that’s driven by psychology and liquidity. Investors get scared, obey stop-loss rules, and act on their commitment to sell at pre-determined points (-8%, -10%, etc.).

Investors get margin calls. Investors panic.

Fundamental events are much simpler: earnings. If corporate earnings fall, so do stock prices.

Right now, stocks are selling off mostly because of China and other emerging markets, and a little bit because of the Fed and interest rates. In other words, this is a technical event. It’s happening because of a change in sentiment.

Earnings were pretty good for the second quarter. U.S. fundamentals are good. Could China’s problems bleed over to the U.S. economy? Sure, of course they could. Emerging markets are already being affected by China’s slowing growth.

But remember: The U.S. economy is 70% driven by consumer spending. China is half that. In other words, the U.S. economy is somewhat insulated to what goes on in the global economy, but not 100%. If the global economy falls apart, U.S. corporate earnings will get hit (and we’ll have a fundamental event).

This makes it a lot easier for me to hold my nose and buy some quality stocks.

Currency Crisis

The best parallel we have for the current sell-off is the Asian Currency Crisis that began in the summer of 1997.

For a few years, the so-called Asian Tigers were growing like crazy and attracting a ton of foreign money. But the economies overheated, foreign investment flooded out of the countries, and they crashed.

The Asian Currency Crisis basically ended in 1998 when Russia defaulted on its debt.

Yes, the currency crisis did affect U.S. consumer spending a little. Personal consumption as a percent of GDP fell from roughly 67.5% to 66.5%.

But the dip for spending and for the stock market didn’t last long. In the third quarter of 1998, the S&P 500 jumped over 30% to new all-time highs.

I can’t tell you that this sell-off is over. It probably isn’t. It’s happened so fast that it feels as though there should be another shoe to drop. And I can tell you that investors will be waiting for that other shoe, at least for a little while.

Still, for me, there is blood in the street. And that means you have to be thinking about buying quality stocks at these levels.

They may not rally today. They may not rally tomorrow or even this week. But a month or two from now, prices will likely be higher. So get your shopping lists ready…

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.