S&P 500 Reaches 4-Year High, Due For A Correction

 |  Includes: BRXX, MCD, SKF, TSM
by: Apple Grade Stocks

This chart forecasts my belief of future S&P 500 stock price movements (the red line). Very soon, a contraction will continue until mid-late October, possibly from a catalyst such as unexpected Fed action. As I will show, there are many financial indicators demonstrating that there will be a contraction in stock prices for the duration of the current quarter before gains resume, presenting a premium buying opportunity in mid-late October.

I forecast a further decline in the growth rate of US GDP for Q3 2012, leading to a huge increase in US GDP in the fourth quarter of 2012. I believe Q4 2012 will form a US GDP growth high leading into the fiscal cliff of 2013.

Though the US GDP numbers only come out every 3 months, the blue Purchasing Managers Index (PMI) in the below chart (an indicator of the economic health of the manufacturing sector,) is monthly. Therefore, the more recently acquired data from August 2012 for the PMI as opposed to June 2012 for US GDP growth (red), makes it possible to forecast a future GDP growth number from already accumulated PMI data. A high correlation between the PMI and GDP is apparent, making it likely that the GDP growth data for September 2012 will follow the movement downward of the PMI, and disappoint expectations. The turquoise line indicates where I think the GDP growth is headed.

One reason for this is that the PMI has greatly diverged negatively from the orange S&P 500 since June 1, 2012. While the S&P has grown 15% since this day, the PMI is down 7.2%. Since this day, the PMI also dipped below 50 for the first time since July 2009, when the US was in the depths of a recession. This is an important indicator because a PMI above 50 represents a common opinion among business managers of expansion of the manufacturing sector, while below 50 projects contraction. To measure the negative historical divergence of the PMI from the S&P, I divided the S&P 500 by the PMI. The higher this ratio is, the greater the negative divergence of the PMI from the S&P. Moreover, given the S&P 500's high correlation with the PMI, the greater the chance the S&P will follow the PMI downwards resulting in a contraction, and the greater the stock market risk.

A current S&P/PMI of 28.99 is the highest it has been since its May 16, 2008 ratio of 29.11, when the S&P 500 was at 1425, leading to one of the greatest crashes in history, and a stock market low of 676 on 3/9/09. For comparisons sake, the largest positive divergence in the 6 year time span of this graph had an S&P/PMI of 18.26, its lowest level on July 2, 2010, and by the time the two crossed again on May 20, 2011, the S&P had gained 30.3% and reached 1333. Though this by no means signals another 2008 caliber crash instantly, it is an ominous sign for the future.

The delayed nature of this measure can be seen from the August 4, 2006 initial negative divergence of the PMI from the S&P, which is strikingly similar to the one in June 2012. However, it was not until October 3, 2008, more than two years later, when the two crossed again and the full effect of this 2006 signal became apparent. So, while I don't believe a serious stock market crash other than an about 10% correction can happen until at least the fiscal cliff of 2013, it remains highly likely that these two indicators will cross again at some point.


My US unemployment projection is further evidence of the common them of a short-term stock market correction in Q3 2012 followed by huge GDP, stock market, and unemployment growth to finish off the last quarter of 2012, although my belief in a long-term downward trend in 2013 after this Q4 gain of both US GDP growth and unemployment remains.

The above chart of the number of US building permits shows that the housing market is indeed picking up, though it still remains at historical lows. While this long term upward trend may lead to very positive economic effects in the far future, the fact that new houses are being built at a slower pace than during the depths of the housing crash of 1980s leads me to avoid any irrational exuberance.

These above charts show that the supply and demand for houses finally reached equilibrium around January of 2012, forming a solid price bottom, shown by the chart on the left. The chart of the right, which graphs the inverted supply (blue) versus percent price change (red) in the San Diego area, shows that price is closely correlated with supply. As supply goes down (or up on the inverted graph,) price goes up. While there could be many reasons for this recent constrained supply, such as home owners not wanting to sell at these price levels and taking their homes off the market, the near 10-year low in US building permits shown in the previous chart shows there may be no end to this constrained supply in the near future, and housing prices have nowhere to go but up. All of this data leads me to believe that while we may not see any above average positive effects from the housing market on the stock market for quite a while, now may be an excellent time to invest in real estate as housing prices are near 8-year lows, and seem to be forming an upward trend.

Click to enlarge

The US consumer confidence, on the other hand, is in a definite downward trend since the early stages of 2012. It is lower than in June when the S&P hit a yearly low of 1280 and corrected 10% from early April highs of 1413. The S&P is now at 1435 despite even lower levels of consumer confidence. This once again indicates that the stock market has gotten ahead of itself, and a correction is due.

This graph shows core inflation of about 2% for the US dollar throughout 2012. This should continue, and as a result, I will not allocate much of a position into cash except to take advantage of a possible market correction in the near future.

Asset Allocation Model

ETFs: 40%, mainly to invest in inverse derivatives of the stock market such as SKF. Also, some allocation into Lithium for exposure to Lithium-Ion batteries, which are in electric cars, iPhones, laptops, etc. Possibly BRXX, a Brazilian infrastructure ETF as they ramp up for the 2014 World Cup and 2016 Olympics, and the Brazilian government has already committed 66 Billion to infrastructure projects.

Stocks: 40%, to invest in safe havens, such as McDonald's (NYSE:MCD) and dollar stores. Primarily budget industries, but some bullish bets to counteract and diversify in the case that I am wrong about the direction of the market. For example, technology stocks such as Taiwan Semiconductor (TSM), which manufactures semiconductors for the A6 microprocessors which will be in the upcoming iPhone 5, and will benefit from its production ramp up.

Bonds: 15%: Bonds are yielding historically low levels, so I will not allocate very much into them. With high debt of countries and high risk of default, I will put an emphasis on corporate bonds.

Cash: 5%, as only depreciation is possible, and in the event of a market downturn, I will sell my inverse stock market ETFs to raise cash to purchase discounted stocks.

Disclosure: I 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.