Summary

  • The S&P 500 Index looks strong, but is becoming increasingly fragile.
  • A correction may be imminent. How far can we expect stocks to fall?
  • Don’t fear the correction. Instead, seek to capitalize.
  • This idea was discussed in more depth with members of my private investing community, Global Macro Research. Get started today »

Strong, but fragile

The S&P 500 Index is seemingly unstoppable. What global depression, right? The benchmark index closed at yet another new all-time high on Tuesday and is now +4% above the pre-COVID-19 peak on February 19. Despite this relentless strength, the rally in stocks is looking increasingly fragile. The following are five reasons why a correction in the S&P 500 may be imminent.

1. Increasingly narrow breadth

The U.S. stock market continues to set new all-time highs driven by an increasingly shrinking set of individual stocks. As one of many signs of how narrow market breadth has become lately, we can see from the chart below that, while the headline S&P 500 Index has surged by more than +4% since August 13, the equal weighted S&P 500 Index is barely positive while the mid-cap S&P 400 and the small cap S&P 600 indices are lower by roughly -1% to -2%.

This divergence in performance is striking, for if the small set of tech and tech adjacent stocks that have been driving the S&P 500 to new all-time highs were to falter, the shift to the downside could be swift. The fact that most of these market leaders are already trading at historically extreme valuations is all the less encouraging.

2. Growing fear

The market itself is already signaling fear about the potential for a correction. In one of the more extraordinary positive correlations as of late, the S&P 500 Index has been repeatedly setting new all-time highs at a time when the CBOE Volatility Index, or the VIX, has been soaring. To this point, while the S&P 500 Index has risen by +4% since August 17, the VIX has jumped by +20% over this same time period.

Now, it would be one thing if the VIX was shifting higher this way from the low teens. But it is far more disconcerting to see the VIX spiking from the low 20s to the high 20s as it is today. In other words, the market was already expressing elevated fear about the potential for a market correction simply by the fact that the VIX remains stubbornly above 20, and the recent spike toward 30 suggests that these concerns are compounding.

3. Historically negative real yields

The 10-Year U.S. Treasury yield closed on Tuesday at 0.68%. At the same time, the 10-Year Breakeven Inflation rate is 1.76%. This means that investors that own 10-Year U.S. Treasuries today are accepting a -1.08% yield after accounting for inflation expectations over the next decade. As the chart below shows, this is a historically low negative real yield since the start of the new millennium.

The only other time real yields were negative to nearly the same magnitude was in late 2012 and early 2013. The risk here for stocks is that, if we see a sudden and sharp rise in real yields similar to what we saw take place in May 2013, it would likely be accompanied by a correction in the S&P 500 Index. This is because such a rise in real yields would be brought about by a sharp move higher in the 10-Year U.S. Treasury yield, which has been a particularly destabilizing event for stocks in the post Great Financial Crisis period.

4. Overstretched and overbought

It is already notable that the S&P 500 Index closed on Tuesday with a Relative Strength Index (RSI) reading over 79. To put this reading into context, an RSI reading at or above 70 is a signal of overbought conditions and that a period of consolidation at best and correction at worst is overdue.

But the S&P 500’s increasingly widening premium over its key moving average (MA) trend lines. At the end of Tuesday’s trading, the S&P 500 is now trading at a 7.69% premium above its medium-term 50-day MA, 14.23% premium above its long-term 200-day MA, and 17.66% premium above its ultra long-term 400-day MA. Why are these premiums notable? The U.S. stock market has only traded at comparable or higher premiums to these long-term MA trend lines on 50 trading days (out of more than 22,600) over 10 separate time periods since 1934. In each of these past instances, the stock market subsequently corrected anywhere between -5% and -20%.

5. September

The final reason is that if there is any time of the year where stocks are most prone to falling into correction, it is the month of September. Over the last ninety plus years, the U.S. stock market gains on average in nine out of twelve months of the year. As for the exceptions, February and May are effectively flat on average. It is only the month of September that stands out in falling by roughly -1% on average. While -1% sounds fairly benign, it is important to emphasize that one arrives at this negative -1% for September by combining some very good with some notably bad monthly returns over this long-term historical time period. And if there is a time when U.S. stocks are particularly prone to downside risk, history has shown that September is as likely a month as any for such a correction to take place.

Latest correction readings

So, what is the latest on how far we should expect the S&P 500 Index to fall if such a correction takes place? Use the moving average lines cited above as your guide. A roughly -7% decline would take us back to the 50-day moving average, while a -12% drop would return us to the 200-day and a -15% correction to the 400-day. Be prepared for any such decline in this range.

Seek to capitalize

While the magnitude of such declines sounds jarring, they must be viewed in context. Such declines represent nothing more than regressions to the mean. In other words, the uptrend in stocks would remain very much intact even with a -15% correction in the short term. Moreover, we know with a fairly high level of certainty that the U.S. Federal Reserve, which has kept its balance sheet flat throughout the summer, will not let the U.S. stock market drop very long or far before it will likely intervene with verbal or actual policy support to reassure stock investors once more.

As a result, investors should view a short-term correction not as a reason for immediate concern but instead as a potential opportunity to selectively add to stock allocations. More pronounced longer-term risks remain and continue to accumulate, but they remain neutralized in the meantime, thanks in large part to the Fed’s ongoing support.

Are you concerned about lingering risks despite stocks trading at all time highs? Are you interested in exploring attractive opportunities beyond U.S. stocks?

If so, come join us on Global Macro Research, where we apply a contrarian investment approach in preparing for risk in the future while positioning for opportunity today.

Author: Eric Parnell

Source: Seeking Alpha: 5 Reasons A Stock Correction May Be Imminent

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