The Market's Downside: S&P 950
It’s amazing to ponder the fact that less than two weeks ago, the S&P 500 (SPY) was near its highs at 1,345 and the Nasdaq 100 (QQQ) was making new highs at 2,438. The buzz at the time was that the market seemed poised to explode to new heights. Those days seem eons ago. Everybody has “aged” a great deal since then.
In that context, it is a bit difficult to think in terms of the S&P 500 at 950. But it’s important to make the mental adjustment, because the S&P 500 at 950 is not far fetched, by any means. Furthermore, no Armageddon is required to reach this level.
The Basis for 950-1,020 On the S&P 500
Less than a year ago, in September of 2010, the S&P 500 was in the 1,040s based on fears of a double dip recession. There is no reason to think that if fears of a US recession continue to intensify as they have in the past few days that we could not revisit these levels again.
Just slightly over one year ago, in July of 2010, the S&P plunged to the 1,020s on fears of contagion from a European debt default crisis. Interestingly, at that time, the major problem was essentially Greece. Talk of contagion to the sovereign debt markets in Portugal, Spain and Italy was rather fanciful speculation. Today, the contamination of Portugal, Spain and Italy is a frightening reality with global bond markets essentially pricing in some level of default these nations. Thus, in many ways, the situation in Europe is much worse today than it was in July of 2010. In that context, revisiting 1.020 on the S&P 500 is hardly far fetched.
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At this time, I have set 950-1,020 on the S&P 500 as a potential band of support for the US equity market in the event that fears of a recession in the US intensify and/or concerns about a sovereign debt crisis in Europe are sustained. I derive this level based on two criteria:
- Horizontal technical support lines which stretch from 2008 to 2010.
- A valuation model which I described here, in which I demonstrate that a violation of the 950 level would represent a break historically “normal” valuation parameters, going back in history 140 years to the 1870s.
Bottom line: There are ample recent and longer-term historical precedents to suggest that the S&P 500 could test the range between 950 and 1,020.
I would not expect the S&P 500 to break the lower limits of the “normal” valuation range (950) unless the prospects of either a default of a major sovereign European nation such as Spain or Italy and/or a US recession become perceived by the market as imminent threats.
Up until recently, investors in US equities were operating under the assumption of a sustained economic recovery that would accelerate beyond 3.0% GDP growth in the second half of 2011. Furthermore, investors have assumed that sovereign defaults in countries such as Spain and Italy were not serious possibilities.
With scenarios of major European debt defaults and a US recession currently “on the table” in investors’ minds, a decline of the S&P 500 to the 950-1,020 range is a real possibility.
Do I think that an S&P 500 at 950-1,020 is likely? I do not think that it is the most likely scenario. However, I do factor this scenario into the distribution of probabilities that I work with.
I currently assign a roughly 35% probability to a test of the 950-1,020 area on the S&P 500.