April 2nd, 2017

Is a stock market correction coming?

The Trump Bump is approaching its 4-month birthday causing everyone to ask how long it will be before a correction? For a long time, we’ve envisioned a target of 2450 for the peak before the correction. On March 1, the S&P 500 touched 2400 on an intraday basis, or just 2% under the price target.

But things are in flux. The economy continues improving, business and homebuilder optimism is near record highs and the labor market is tightening generating wage increases for the first time in years.  The only fly in the ointment is the political backdrop and the risk that it poses for Trump’s economic agenda.

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Should We Sell Everything?

We’re hearing it more and more these days. “I think we should sell everything” and “The bull market is eight years old with only two pauses; it can’t go much higher” or “The Trump Bubble has to pop soon and I want to get out of the way.”  We can’t argue with these sentiments because they are logical and sound; but are they feelings to which we must respond and react? No doubt a correction is inevitable. It’s just that no once can predict with certainty when, from what level and how deep. A 5% correction from Friday’s 2378.25 close may come next week or a 30% correction could begin at S&P 2600 sometime this coming winter. Your guess is as good as the next guys.

What we can say with some certainty is that while the causes that bringing on the next correction will be different from previous ones, it will evolve pretty much the same as did those earlier ones. Everyone won’t jump off this speeding market train at the same time.  As a matter of fact, market sentiment may be in the process of changing from bullish to bearish even now. What we will be able to observe, however, is how slowly changing sentiment of the majority of investors reflects itself in the prices they are will to pay or forced to accept in their trades.

We have a couple of tools to help us deal with our collective xenophobia about the coming correction. For one, there’s our Market Momentum Meter which indicates the intensity of sentiment changes as measured by the rate and degree of price changes from historical trends. The second is that over a long stretch of history including 3 wars, 9 presidential administrations from both parties, many economic cycles including booms and busts …. through all that fundamental economic and political background noise, the market has inexorably rising at an average rate of 7.5% per year. During booms and bubbles it has contained by boundaries 45% above and below a trendline at the midpoint.

I’ve assembled a look back at the three prior corrections of this 8-year bull market. Granted, they all happened within the context of a soft economy back-stopped by the Fed’s Zero Interest, Quantitative Easing easy money policy so they could have been worse. But the next correction will happen within the context of an economy no on the mend, an administration, if they can get their act together, that promised tax, infrastructure, regulations reform programs and a Fed that continues finding ways to act constructively.

  • This is the 8-year Fed QE Bull Market that’s contained within the 7.5% Reversion to the Mean channel stretching back to 1939.  The purpose of including this is to show how long it took for each of the three previous corrections to evolve. S&P 500 - 2009-2017 Corrections
  • The 2010 correction:  Stocks got off to a good start in January but worries about European debt quickly deflated that early optimism. As the market got accustomed to these daily anxieties, and Greece managed to crawl out of its default hole, stocks started to crawl higher. On Aug. 27, Fed Chairman Ben Bernanke’s mere hint of another stimulus put stocks on an upward trajectory for the rest of the year. But let’s not forget May 6, when the “Flash Crash” shaved 10% of the Index in a matter of minutes only to have it recover by day’s end.
    S&P 500 - 2010 Correction
  • The 2011 correction:  From up 8% to down 12%, stocks finished 2011 with an annual change of 0.003%…about as flat as you can get. Investors are happy to put 2011 to bed.  From unrest in the Middle East due to the Arab Spring revolutions and Japan’s devastating earthquake to Europe’s worsening debt crisis to the ongoing bickering in Washington of the debt ceiling, stocks experienced some violent swings.
    S&P 500 - 2011 Correction
  • The 2015 correction: The year started with what we called the “Big Squeeze” as the market fluctuated in a narrow band and failing to breakout to new highs several times and instead plunged more than 10% in a week in late August on a wave of selling triggered by fears that China’s economic slowdown was turning out to be worse than feared.  Perhaps not coincidentally, the stall at the Big Squeeze was just below the intersection of two significant resistance trendline: the midpoint of the Reversion to the Mean channel and the top of the 2009 Fed bull market channel.A strong recovery after retesting the August lows failed again to penetrate the earlier ceiling as fears about China resurfaced causing markets to tumble again in January. We anticipated the big 30% corrections coming out of what appeared to be an emerging head-and-shoulders reversal top (with the Big Squeeze being the head) throughout the year. But the Fed again stepped in and prevented it from happening. The Meter returned to Bullish Green in April 2016.
    S&P 500 - 2015 Correction
  • Current: Which brings us up to date. The previous corrections took more than 4 months to emerge so, when the next correction comes it, too, should not begin with a sharp downdraft but a few months of fluctuations within a narrow trading range. The Meter has been unwaveringly Green since April 26,2016. It will take some time and sideways motion for the Meter to turn to yellow and red this time too. Our imaginary “ceiling” of the midpoint trendline is only 4% higher than Friday’s close.  But it’s only a benchmark and there’s no guarantee that it will stop the market euphoria that seems to be bubbling up.
    S&P 500 - 20170317

Bottom line, all this talk about selling everything in anticipation of a correction that clearly is coming, at some time and at some point in the future is premature. We can be cautious, worry and even be anxious but we don’t yet need to act.

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  • Shradhha

    Thanks for this interesting information this is really helpful for me.

    Capital Vradhhi