Pullback, correction or bear market? Market selling unnerved investors, who just weeks ago were assuming another year of strong gains.

Japan’s Nikkei, the star of 2013, is down 14 per cent since December 30th. Last week, it broke its 200-day moving average for the first time since markets began pricing in Abenomics in late 2012.

It’s trading at levels seen last May, as is the Dow Jones Industrial Average, which also breached its 200-day average for the first time in over a year.

The S&P 500 last week fell 2.7 standard deviations below its 50-day average – the most technically oversold condition in 14 months.

Still, despite the agonising over emerging markets, and the hyperbole about a $3 trillion global stock “wipeout”, the MSCI world index has fallen by less than 6 per cent.

It may get worse, but four-month lows are not cause for panic. Money manager and blogger Josh Brown puts it well: "If a correction of between 10 and 20 per cent is unbearable to you mentally or financially, that means you've either got more money than you should invested in stocks or you're kind of a fairy."

Mind the gap 

Emerging market stresses may be the story de jour, but the issue has been bubbling away for some time now.

MSCI's emerging markets index fell 5 per cent last year, even as the S&P 500 soared 30 per cent. Even before the recent sell-off gathered steam, Merrill Lynch said sentiment was close to capitulation, with the percentage of investors underweight in emerging markets two standard deviations below its 10-year average. There have been 14 consecutive weeks of outflows from emerging market funds – the longest streak since 2002 – with the largest weekly outflow since August 2010 recently recorded.

Can it get worse? Yes – 2001 saw a streak of outflows almost twice as long.

At some stage, however, valuations will make investors pause. MSCI’s emerging index trades at nine time forward earnings, below its 10-year average of 11. Developed markets trade on 15 times earnings, above their long-term average of 13.

The valuation gap is at its widest since October 2008. That gap will narrow, the only question is when.


Macro factors are big picture
2013's lacklustre earnings didn't prevent US markets from roaring higher. Now markets are retreating, just as the earnings picture improves.

So far, 74 per cent of companies have beaten earnings estimates; 67 per cent surpassed revenue estimates; growth estimates are being revised higher. Bespoke Investment Group notes the average stock has gained 0.39 per cent on its report day, despite the wider sell-off. In other words, markets are being driven by macro, not micro factors. That stocks are rising on report days, suggests Bespoke, “is a good sign for the long-term health of the market”.

Bearish start not a problem
The S&P 500's start to February was its worst since 1933, and follows on from a miserable January.

As goes January, so goes the year? Since 1973, notes the Stock Trader’s Almanac, a positive January was followed by average gains of 11.2 per cent.

A negative January saw average annual gains dwindle to 0.2 per cent.

We wouldn’t worry. Big gains followed down Januarys in 2009 and 2010. Since 1950, a negative January was followed by gains on 13 occasions. The 2014 performance was the seventh-worst January over that period but as Schaeffer’s Investment Research notes, that means nothing – in the worst six cases, the S&P500 rose on five occasions, averaging returns of 9.7 per cent.

Looking at the next six worst months, markets went on to decline on five occasions. In other words, there is no pattern at all.

February’s poor start is also irrelevant. The Paststat blog analysed the S&P500’s 20 worst starts to a month over the last 20 years. On 14 occasions, the index was higher a month later.

The median is the message
The S&P 500's cyclically adjusted price-earnings ratio (Cape) suggests stocks are almost 50 per cent overvalued. A much-followed indicator, which has historically proved telling, Cape's relevance is questioned by Prof Jeremy Siegel, a market bull who warns the ratio is now misleading due to accounting changes that artificially depress reported earnings.

Siegel prefers National Income and Product Accounts (Nipa) data instead of S&P 500 earnings data – a move GMO analyst James Montier describes as "slightly surreal".

The suspension of mark-to-market accounting in 2009 allowed banks to “lie with impunity”, says Montier. Earnings may have recovered too fast, negating the changes to which Siegel refers.

Investment manager and long-time Cape advocate Mebane Faber says Siegel's arguments actually "make a lot of sense".

However, even using Nipa earnings data, US stocks are 21 per cent above their median, he says. “The conclusion is the same”, says Faber. “Stocks are overvalued, just how much is the question”.