How Far Will Stocks Fall?

| About: SPDR S&P (SPY)

Summary

Stocks neither rise nor fall in a straight line.

Instead, they are expected to retrace a portion of their advance or decline over time.

This natural force has been largely missing from the stock market over the past several years.

What does this imply for stock prices once the need to retrace a portion of their post-crisis advance finally returns?

Stocks neither rise nor fall in a straight line. Instead, when stocks are rising, they are expected to retrace a portion of their prior advance. Conversely, when stocks are falling, they are expected to retrace a portion of their prior decline. Evidence of this phenomenon are found throughout capital markets over time. But this natural force has been largely missing from the stock market over the past several years. Knowing that the laws of nature have not been repealed despite the best efforts of global policymakers, what does this imply for stock prices once the need to retrace a portion of their prior advance finally returns?

Fibonnaci Retracements

Leonardo Pisano Bigollo was a 13th century mathematician who had among his accomplishments the introduction of what is known as the Fibonacci sequence, which provides the basis of the golden ratio that can be found throughout nature and architecture. These same properties also have widespread application in financial markets, as securities prices have demonstrated that they move over time with these same proportions.

The way the Fibonacci sequence manifests itself in financial markets is as follows. Securities do not rise or fall in a straight line. Instead, they retrace a portion of their prior advance or decline. This is called retracement and helps explain the oscillating patterns we almost always see associated with securities prices. And these same principles have held true for the S&P 500 Index (NYSEARCA:SPY) over time.

The three key retracement levels associated with the Fibonacci sequence are the following: 38.2%, 50.0% and 61.8%. In short, if a stock price rises or falls over any period of time, it is anticipated that it is likely to retrace 38.2%, 50.0% or 61.8% of this advance or decline from any given peak, before continuing its move up or down.

These forces of the golden ratio are not only demonstrated to hold true over short-term periods of time, as demonstrated below, but also over long periods of time stretching over decades. For example, the following is the Fibonacci sequence for the S&P 500 Index from the post-1987 crash lows through the calming of the financial crisis in 2009. Note that we had effectively two 61.8% retracements to date of the stock market advance that began during the advent of the "Fed put" through the financial crisis.

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Going back a bit further, the Fibonacci sequence that begins with the start of the secular bull market in 1982 through the 2007 market peak signaled the potential for a 61.8% retracement in the S&P 500 Index at 664.01 that was less than three points from what ended up being the final bottom in March 2009.

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The laws of nature exist for a reason, and they are difficult to repeal. And for those who try in vain, the consequences are almost always dramatic once they finally come home to roost.

How Now Leonardo?

During the early years following the calming of the financial crisis, the S&P 500 Index was following this behavior, as would be expected. Coming off of the March 2009 lows, stocks peaked in April 2010, before retracing almost exactly 38.2% of their advance by June 2010. Stocks found their footing and continued their advance.

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Stocks peaked again in April 2011, before once again retracing 38.2% of their trough-to-peak advance by August 2011. Once again, stocks stabilized and continued their advance higher.

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What has been notable since 2011, however, has been the following. Despite two fleeting 38.2% retracements based off of the August 2011 lows, the stock market, as measured by the S&P 500 Index, has experienced virtually no measurable Fibonacci retracements for many years now.

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And outside of two fleeting pullbacks several years ago in 2010 and 2011, it has been the general absence of any meaningful retracements since the calming of the financial crisis in March 2009 that has been most notable.

Did the U.S. Federal Reserve manage to repeal the laws of nature by entering into one of the most aggressive monetary policy stimulus campaigns in history with the launch of QE3 back in January 2013? (I say "one of the" because I would contend that the relatively more aggressive actions of the Bank of Japan would leave even the well-intended, intrepid former Fed chair Mr. Bernanke blushing.) Knowing that I have yet to see the laws of nature repealed in the past, I'm going to stick with the fact that they continue to remain in force going forward.

What does this imply for the U.S. stock market? Basically the following. The longer stocks go without the healthy retracement of their Fibonacci sequence, the more dramatic the retracement process is going to look and feel. And this assumes the reasonable expectation that the U.S. stock market continues its long-term uptrend that began under the buttonwood tree more than two centuries ago.

How Low Might We Go?

Let's suppose that May 2015 peak in the S&P 500 represents a level from which the market now needs to retrace.

The bulls would reasonably make the following argument. They would contend that the last Fibonacci retracement that took place in November 2012 formed the basis for the next advance in stock prices, and that a Fibonacci sequence can be constructed off of this bottom through the May 2015 peak. And by this measure, the bulls would contend that the stock market has been undergoing a Fibonacci retracement process in recent months, as the August and September 2015 declines followed by the February 2016 plunge have all represented 38.2% retracements of the advance that has taken place since late 2012. This is a valid conclusion for those who are contending the bull market remains very much still intact.

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The bears also have a case from a longer-term perspective, however. They would suggest that the bull market has run largely uninterrupted from its March 2009 lows to its May 2015 highs, and that a Fibonacci retracement is now long overdue to keep any current long-term uptrend intact. And the declines that we have seen since the May 2015 highs are likely only the beginning of a larger cyclical bear market that would result from this overdue Fibonacci retracement process. The levels they would then be targeting on the S&P 500 would be a 38.2% retracement to 1573.97, which would effectively represent a return to the previous all-time highs, a 50.0% retracement to 1400.76 and a 61.8% retracement to 1227.54.

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The bears could bolster their argument further from a valuation perspective. For at current earnings at $86.47 per share on the S&P 500 Index, these retracement price levels would imply market P/E ratios of 18.2, 16.2 and 14.2, respectively, times trailing 12-month as-reported earnings. All of these valuation levels are perfectly reasonable given that the market has historically traded at an average P/E of around 16 times trailing 12-month as-reported earnings.

Not to be outdone, the secular bears also have a reasonable case. These are investors who have an ultra-long term view on the market, and in certain respects, may also be considered table-pounding secular bulls, depending on one's perspective. These investors see the retracements based off of the lows from the 1980s that have taken place since the start of the millennium, and are open to the fact that we may see yet another such retracement in the near term before it's all said and done. For these investors, the levels they would then be targeting on the S&P 500 would be a 38.2% retracement to 1358.52, a 50.0% retracement to 1118.76 and a 61.8% retracement to 878.99, the last of which would effectively represent a return to the 2002-03 and 2008-09 lows, assuming the potential for a modest overshoot to the downside.

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Once again, these secular bulls in secular bear clothing could bolster their argument from a valuation perspective. Once again, assuming current earnings per share of $86.47 on the S&P 500 Index, these retracement price levels would imply market P/E ratios of 15.7, 12.9 and 10.2, respectively, times trailing 12-month as reported earnings. Once again, reasonable valuations all. In fact, these are valuations that are sufficiently low that, to many, they may signal the end of a secular bear market and the extended period of volatility we have experienced since the start of the new millennium. These, of course, are the buying opportunities that come only once or twice in a lifetime.

The Bottom Line

The laws of nature have not been repealed. They may have been delayed, but certainly not repealed. And assuming that the laws of nature that include Fibonacci retracements will return, it is reasonable to consider what we should expect once they do. Perhaps they are already playing out, as the bulls can reasonably contend. Then again, perhaps they are yet to come. If indeed the bears are proven right in this regard in the end, it is important to keep the following points in mind. Any such declines are likely to look and feel dramatic, but they are only part of natural market forces playing out. Stocks have climbed almost uninterrupted beyond all recognition in recent years, so the potential should be accepted that they may now need to give back quite a bit to continue their centuries-long advance higher. But barring a catastrophic policy mistake, any such retracements will eventually pass.

But recognizing that it could take up to a few years for any such future Fibonacci retracement to fully play itself out, it remains worthwhile to have a plan in place to at least protect, if not capitalize on, such an outcome. For those open to the possibility of such an outcome, please consider joining us on my premium service on Seeking Alpha called "The Universal". The service targets winning investment portfolio strategies across the asset class universe in both bear and bull markets, with a focus on attractive return opportunities, risk control and loss minimization across all asset classes, including stocks, bonds, commodities and hedges. We respect the laws of nature and recognize that a balanced view both to upside and downside opportunities must be maintained over the long term. Concerned that "The Universal" may not be right for you? The good news is that you are protected by a free two-week trial as well as Seeking Alpha's unconditional prorated money-back guarantee. Thanks and I look forward to collaborating with you on "The Universal".

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: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.