Is A Stock Market Correction Imminent?

by: Eric Parnell, CFA


The stock market is overdue for at least a modest pullback in the near-term.

When exactly might we expect such a correction to take place?

How far can we expect the stock market to fall once it finally arrives?

How should investors react once this correction finally takes place?

And what will this anticipated correction mean for the sustainability of the long running bull market?

It is widely held even among the most bullish stock investors that the market is overdue for at least some sort of pullback. But this frequently discussed topic raises a number of additional important questions. When exactly might we expect such a correction to take place? How far can we expect the stock market to fall once it finally arrives? How should investors react once this correction finally takes place? And what will this anticipated pullback mean for the sustainability of the long running bull market?

At first glance, it is reasonable to wonder why the topic of a stock market correction is garnering so much attention from the punditry. After all, when looking at stocks through the lens of 2014 returns, the performance of the S&P 500 Index (NYSPY) has been solid but not necessarily exciting. Overall, the major market index has recovered smartly from an early year swoon to advance by roughly +8% year-to-date. This ranks stocks in third place among the major diversified asset classes just a hair behind gold (NYGLD), which has cooled somewhat from its strong run to start the year, and a good distance behind long-term Treasuries (NYTLT) that are up over +15% so far in 2014.

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But upon a broader view of the markets, the solid returns of stocks in 2014 comes on the heels of what was a notably bold performance in 2013 when stocks advanced by over +30% and completely trounced the performance of all major competing (uncorrelated to negatively correlated) asset classes including high yield (NYHYG).

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Such results were unprecedentedly strong for a fifth year of an equity bull market. Moreover, they took place despite what was an otherwise lackluster year for corporate revenue and earnings growth. In other words, stocks have notched a vast majority of their overall gains over the last 18 months on valuation expansion instead of underlying growth. This puts stocks on far unsteadier footing going forward in working to continue to maintain their move to the upside including the potential for greater volatility and price swings once the correction finally arrives.

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Of course, none of this matters in the short-term as long as stocks continue to rise. With this in mind, it should be clearly noted that the uptrend in stocks remains firmly intact. And until we begin to see signs of weakness starting to emerge in this sustained uptrend, it remains more than prudent to remain long stocks in the current environment.

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While the S&P 500 Index uptrend remains ongoing, it is worthwhile to consider whether we are seeing weakness in any other areas of capital markets that may be foreshadowing that a correction in the major stock market indices may be imminent. And some clues are beginning to emerge to suggest that at least some form of a pullback in the S&P 500 may be drawing close.

First, some immediate suggestions that stocks may be growing increasingly tired come from technical measures within the S&P 500 Index itself. For while stocks continue to levitate to new highs, a number of key technical readings including the Relative Strength Index (RSI), the Moving Average Convergence Divergence (MACD) and the Chaikin Money Flow have all been weakening over the last several weeks. While this does not necessarily ensure that a correction is imminent, such divergences between price and underlying technical readings often foreshadow that a pullback may be looming.

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Also, the relative weakness of small cap stocks as measured by the Russell 2000 Index (NYIWM) versus the S&P 500 Index continues to widen. While the results between these two indices were highly correlated through the first quarter of the year, they have completely diverged since the beginning of April. And while the large cap S&P 500 Index has continued to push higher in July, it has been a generally lousy month for the Russell 2000 small caps to date. It is also notable that the Russell 2000 has notched two distinct breaks of its upward sloping 200-day moving average over the last few months. Such breaches of support are often seen in the very early stages of a bull market peaking process, and the possibility exists that small caps may have now entered this topping phase. Only time will tell. With all of this being said, while movements in small caps have often occurred in advance of trend shifts in large caps throughout market history, this has not always been the case. But it remains worthwhile to continue watching how the Russell 2000 holds up in the coming weeks as a potential warning signal for the S&P 500 Index going forward.

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The more recent divergence in mid-caps as measured by the S&P 400 Index (NYMDY) relative to the large-cap S&P 500 Index lends support to the potential for a looming broader market pullback. Large caps and mid-caps had been moving in tandem throughout the year through the end of June. But since the start of July, mid-caps have fallen off the pace while large caps continue to rise. The split between the two is not yet wide enough or long enough to warrant immediate concern, but a monitoring for a continuation of this pattern in the coming days and weeks will be important in identifying whether the S&P 500 Index might soon follow to the downside.

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One more notable break up in recent months has taken place between the S&P 500 Index and the developed international MSCI EAFE Index (NYEFA). Both major market measures had been moving in lockstep thus far in 2014 through late May save a brief downside spell for international stocks in March, but they have since split and the gap between the two continues to widen.

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Of course, one of the most notable aspects of the S&P 500 Index over the last several years has been its ability to continue rising while all other major market indices including those most highly correlated to the large cap stock benchmark increasingly fall to the wayside. At some point the S&P 500 will finally surrender its upside move, but its resilience in the face of heavy fire at times along the way has been most impressive. As a result, it may still continue rising even if all other segments of the market have exited the ride.

But even if the S&P 500 Index is determined to push alone to the upside, it also faces a market rhythm challenge in doing so without posting at least some sort of correction in the near-term along the way. Even during the rosiest periods of stock market gains in 2013 and early 2014, stocks would endure periodic measurable corrections. Such short-term pullbacks took place roughly every month and a half on average and would last for at least a week or two if not longer. But it has been more than three months through today since stocks have experienced even a minor pullback lasting more than a couple of days. Thus, even if the decline in stocks is only minor at a handful of percentage points, stocks are overdue for such a move in the current market environment.

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What To Do When The Correction Finally Arrives

A correction in the U.S. stock market is now overdue. But what actions should investors take if any in anticipation of such a pullback? For the long-term investor, the answer is very little, at least at first, as they will likely be better served to initially stand their ground with positions if not snap up a position or two on any short-term pullback. This is due to the fact that stocks enjoy an extensive netting of technical support at current levels. Stocks have repeatedly bounced off of key technical levels such as the upward sloping 20-day, 50-day, 100-day and 150-day moving averages throughout the latest market rally that began at the start of 2013. And until the S&P 500 Index begins to sustainably break these important technical levels and begins to test the still upward sloping 200-day moving average over the period of a few months, stocks are likely to maintain their short-term resilience. Moreover, bullishness among stock investors remains sufficiently strong at this point that even if we were to see a sustained correction, buyers would likely emerge to purchase the dips and reverse the downward trend at least on the first or second correction. Such is the nature of market topping processes and how bull markets end, and it will be key to monitor how the market behaves once some of these key technical levels are breached to determine whether a bull market top has finally been established or if the uptrend is poised to continue further. And maintaining patience and holding positions as these initial adjustments play out is prudent as long as it comes with a close watch and the readiness to take action if and when necessary.

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So how much of a correction should we expect before things start to get hairy? Given how much the market has levitated in recent months, the pullback could gain some pace to the downside before we even begin to breach some of the key technical support levels in the current stock market uptrend. For example, the S&P 500 Index closed on Friday at its 20-day moving average. As a result, a -1.6% decline to 1946 would take it to its 50-day moving average, which also happens to reside around its current upward sloping trend line. The next stop would be a -3.6% drop to 1906 and the 100-day moving average, which has served as support on four separate occasions since the start of 2013. The next level would be a -5.0% decline to 1879 and the 150-day moving average, which was the bouncing line for stocks back in early February 2014. From there, the next stop is the critically important support level of the 200-day moving average currently at 1851, which represents a -6.4% drop from current levels. The S&P 500 Index has not breached its 200-day moving average since late 2012, which is a relatively long time for the major market average based on history. Putting this all together, we could see up to a -6.4% decline in stocks from current levels and the bull market uptrend would remain firmly intact.

Of course, a sustained downside move heading toward the high single digits or beyond might suggest that something more than a short-term correction has materialized. The exact nature of the decline including how stocks respond to important technical support levels will be key along the way in determining whether the bull market is finally drawing to a close and the next bear market is lurking not far behind. But even under the more dramatic correction scenario, stocks are likely to give investors at least one sizeable bounce higher before finally capitulating to the downside. This is particularly true given the degree of bullishness present in today's market.

Bottom Line

A sustained correction in stocks is long overdue and may now be imminent in the coming days to weeks. This does not mean that it will happen, but that the probability for such a correction is rising. It may have even already gotten underway on Friday. Only time will tell.

But investors should initially maintain patience under any short-term pullback scenario, as stocks have proven incredibly resilient at this stage of the long bull market run and enjoy extensive technical support not far below current levels.

With this said, a more significant correction beyond the mid single digit range to the downside warrants far greater scrutiny, as it may represent the very beginning of the end for the long running bull market.

Investors will be best served to maintain patience and calm under the latter scenario, however, as history has shown that stocks do not go straight down in the bull market topping process, providing both the time and opportunity to reposition accordingly for the pending bear market and even work to capitalize when the time finally comes. Maintaining a close watch on the markets and your portfolio each step along the way is most important under such a scenario.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: The author is long TLT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long stocks via the SPLV and XLU as well as selected individual names. I also hold a meaningful allocation to cash at the present time.