Are markets heading for another slump?

After an impressive run in 2012 so far, stock markets have just suffered their first significant stumble. Is it just a normal pullback, or the start of something bigger? John Stepek investigates.

So what spooked markets yesterday? In Britain, the FTSE 200 closed down nearly 2%, while in the US, the S&P 500 was similarly whacked.

There may be nothing to it. Markets have had a very impressive run over the past few months. Yesterday was the first day this year that the S&P 500 had fallen by more than 1%.

According to Jeffrey Saut of US financial advisor Raymond James, that sort of streak has only happened in six other years since 1928.

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In other words, stocks have run up too far and too fast. They were due a breather.

Is there any more significance to yesterday's slide than that?

Let's have a look.

The market is running out of positive surprises

The problem for markets is that they've got ahead of themselves. They've been going along thinking that whatever the world's economic problems may be, central banks can soothe them with a big splurge of money.

And as investors get more optimistic, they become more vulnerable to disappointment. As my colleague David Stevenson has pointed out in the Fleet Street Letter, the Citigroup Economic Surprise Index (CESI) points to further falls for stock markets.

In essence, the CESI shows how actual economic data compares to analysts' forecasts. When data is beating forecasts, the CESI rises. When it is missing forecasts, the CESI falls.

What does this tell us about markets (apart from that analysts aren't that good at their jobs)? As data beats forecasts, analysts start to revise up their expectations and so do investors. Positive surprises stop being such surprises. People start to price in' good news.

As a result, it becomes harder for news to surprise on the upside, and easier for it to disappoint. So when the CESI is high (as it is now), chances are, investors' expectations are too high as well. That means any little disappointments can knock them off their stride.

Just within the last couple of months, the CESI hit a peak. It has now started to roll over' in other words, it's falling again. That suggests that the "better-than-expected" data has been exhausted. Now investors will start focusing on the negative again.

Central banks have disappointed investors

The CESI measures US economic data specifically. But more general disappointments have started to pile up over the past couple of weeks.

Last week, just as the European Central Bank was turning on its printing presses again, the Federal Reserve turned cagey about doing a third batch of quantitative easing (QE). That rattled anyone who thought that yet more money printing in the US was a sure thing.

Then, earlier this week, the Chinese decided that 8% was no longer the magic number. Instead, economic growth won't be allowed to fall below 7.5% this year. My colleague Matthew Partridge has more on this story below.

The China bulls are falling over themselves to point out that China is still likely to beat this level of growth. But it does suggest that the chances of another flood of stimulus money from this direction are lower than perhaps markets had hoped. Certainly, the news hasn't done the Australian dollar any favours in the last couple of days.

And now everyone is starting to panic about Greece again. It's a long story, but the short version is that if Greece can't get everyone (well, 90% of private bondholders) to agree to write down its debt, then it might have to force the deal through.

That matters because chances are it would trigger a credit default swap insurance pay-out (and if it doesn't, you have to wonder if CDS will be worth anything ever again). No one's quite sure how that would pan out, but it would be unnerving for markets to say the least.

Get your watch list out and pick your targets

So what happens next? I'm not a trader, so I'm not going to try to call the market direction. And the US non-farm payrolls number this Friday could turn everything around. If the jobs data manages to calm investors, it might push the market higher again.

But this behaviour looks very similar to what we've seen in 2010 and 2011. Investors get over-excited. They pile in on the promise of money-printing. Things look like they're getting a bit better. Suddenly central bankers back off. The market dives again.

Right now, in fact, it strikes me that Fed chief Ben Bernanke actively wants to talk the market down. He's in a bit of a bind really. If investors think he's going to print more money, they'll keep pushing stocks up. But he can't justify more QE if the Dow Jones is sitting at 15,000 and the Nasdaq is heading back towards levels not seen since the tech boom.

The fact is, if the market plunges far enough, he'll step in. But don't expect him to do it just yet.

What does that mean for you? Well, it means you'll probably get the opportunity in the months ahead to buy any stocks you've had your eye on a bit cheaper than you might have thought. So get out your watch list, and start picking your targets. There are plenty of ideas for individual stocks and sectors on our website, and in MoneyWeek magazine every week. If you would like to become a subscriber, you can subscribe to MoneyWeek magazine.

Here are a couple of suggestions to get you going: in terms of sectors, on the financial side, we don't like banks (though if you have to buy one, this is the one to buy). But we are happier with insurers you can get some tasty dividend yields, and they don't look half as risky.

Elsewhere, I'd avoid general miners just now. I still don't think the market is pricing in a Chinese slowdown. But gold miners are worth keeping an eye on. And I'd buy gold on the dips too. Because when the money printing starts again, gold is still among the best ways to protect your wealth if inflation gets out of hand.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.