In a recent article, I had noted that a correction in equities was on the cards. This week, we have finally seen the rally in equities fizzle out. However, the sharp correction that I have been anticipating is still not here. In fact, for the week ended July 27th, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and the iShares Core S&P 500 ETF (NYSEARCA:IVV) saw the highest inflows. Interestingly though, for the same week, the iShares Russell 2000 ETF (NYSEARCA:IWM) saw the highest outflows. I believe that this is a good time to bet on Direxion Daily Small Cap Bear 3X Shares (NYSEARCA:TZA).
Why A Correction Is On The Cards
Two things make me worried about the S&P 500 at current levels. First as the chart shows, the benchmark index is trading near record high levels. This despite the fact that the index is headed for a fifth straight year-over-year decline in earnings.
According to FactSet, it would be the first time that the S&P 500 would record five successive quarters of year-over-year declines in earnings since the third quarter of 2009. The last time we had this scenario was during the period between the third quarter of 2008, when the financial crisis began, and the third quarter of 2009. During this period, we saw a steep drop in the S&P 500. The index only recovered after the Fed began its quantitative easing program. In fact, after this period, the multi-year rally in the S&P 500 began as the chart below shows.
As I have noted before, the S&P 500 is now trading at a multiple of 25.10x earnings. This is well above the mean of 15.6x earnings. Considering the fact that we are looking at fifth straight quarter of earnings decline, this valuation is certainly not justified. As I have said before, this is a liquidity driven rally. The excess liquidity in global markets has resulted in unusual calm in the market as the VIX index below shows. But based purely on fundamentals, a sharp correction is due.
Fund Data Shows Interesting Development
Although fundamentals do not justify the lofty valuations, investors are still pouring money into equities. According to ETF.com, for the week ended July 27th, the ETFs that saw the highest net inflows were SPY and IVV. However, inflows have been slowed down in the last couple of days as the table for daily fund flow below shows. We see a similar trend with IVV.
At the same time, investors are pulling money out of small cap stocks. The ETF.com data shows IWM had the highest outflows for the week ended July 27th. IWM has seen outflows in each of the last five trading sessions between July 21st and July 27th.
There are obvious signs that investors are taking risk off the table and a sharp correction is on its way.
TZA Worth A Look
As I noted, the small cap space is already experiencing significant outflows. In fact the year-to-date chart for IWM shows a very interesting trend.
As the chart above shows the S&P 500 and IWM have tracked each other for most of the year. Year-to-date, the S&P 500 has gained 5.16% and IWM has gained 5.95%. But recently, there is a divergence as can be observed in the chart. The chart pattern suggests that the drop in IWM during a correction could be steeper than the S&P 500 itself. This is an interesting trend and makes TZA worth a look.
TZA remains down sharply for the year. During the January-February sell-off in equities, TZA had climbed up to $70. I believe that a correction this time around could push the ETF to those levels.
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.