Expect A 10-15% Decline In The Stock Market

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by: Michael Bryant

Summary

Technicals show a potential head and shoulders forming.

Investors can expect a 10-15% decline, with a possibility of a 20% decline.

Politics, global instability, Greek Crisis, overvalued U.S. stock markets, debt limit, and declining GDP growth are several other warning signs.

For those who argue that past performance does not guarantee future results, I agree, there is no guarantee. But a statistically significant model result can predict the future, much like how weather forecasters can predict the weather fairly accurately for the next 10 days. After 10 days, the predictions become less accurate but still can give a rough figure based on climate models. The stock market is in a sense a little like weather, a collection of chaos. Instead of using wind shear, sentiment is used. Thus, we should be able to predict the stock market to some degree. And the basis of technical analysis is the study of patterns. As they say, "History repeats itself."

On January 4, 2017, I wrote an article calling to prepare for a fall of at least 19.8%. In the article, I gave a Dow (NYSEARCA:DIA) target of 20,200; a S&P 500 (NYSEARCA:SPY) target of 2,320; a NASDAQ (NASDAQ:NDAQ) target of 5,760; and a Russell 2000 (NYSEARCA:IWM) target of 1,350. As shown in the graphs of the major indexes below, all four indexes overshot their respective targets a month or two ago before pulling back last month. The Dow, S&P 500, NASDAQ, and Russell 2000 closed Friday, March 31 at 20,663, 2,363, 5,912 and 1,386. Both the Dow and the NASDAQ are 463 points and 152 points above their respective targets, but both the S&P 500 and the Russell 2000 are very close to their respective targets. On Tuesday March 21, the market had its first decline of 1% or more since the election, possibly signally the beginning of a market decline. Could markets be finally due for a pullback? Is "sell in May and go away" coming in April? Are there fundamental and technical warning signs?

Source: Stockcharts.com

The Dow seems to be forming a head and shoulders pattern. Technical trader Thomas Bulkowski states that the head and shoulders pattern is one of the best indicators of a market reversal. The price target is 18,250, a decline of 11.7%. Of course, the target could change when the neckline is completed. This would nearly take the Dow back to the day of the election, erasing most of the Trump Rally. Assuming a symmetrical head-and-shoulders pattern, the price should hit its target in about 3-4 months. While the index could head higher in the next few days, the W%R and RSI are at the same level right before the pullback in January of 2016.

Source: Stockcharts.com

The S&P 500 also seems to be forming a head-and-shoulders pattern. The price target is 2,100, a decline of 11.2%. Again, the target could change when the neckline is completed. This would take the S&P 500 exactly back to the day of the election, erasing the Trump Rally. Assuming a symmetrical head-and-shoulders pattern, the price should hit target in about 3-4 months. While the index could head higher in the next few days, the W%R and RSI are at the same level right before the pullback in January of 2016.

Source: Stockcharts.com

The NASDAQ also seems to be forming a head-and-shoulders pattern, although larger than those of the Dow and S&P 500. The price target is 4,450, a decline of 24.5%. Again, the target could change when the neckline is completed. This would take the NASDAQ back to the January of 2016 lows. Assuming a symmetrical head-and-shoulders pattern, the price should hit target in about 7-8 months. The W%R recently entered overbought levels, and the W%R and RSI are at the same level right before the decline that started in November of 2015.

Source: Stockcharts.com

The Russell 2000 also seems to be forming an enlarged head-and-shoulders pattern. The price target is 885, a decline of 35.4%. Again, the target could change when the neckline is completed. This would take the Russell 2000 below its January of 2016 lows. Assuming a symmetrical head-and-shoulders pattern, the price should hit target in about 8-9 months. The W%R recently entered overbought levels, and the W%R and RSI are at the same level right before the pullback in December of 2015.

In my 19.8% article, I linked today's market to the beginning of Ronald Reagan's early years as President. Reagan was elected on November 4, 1980. According to the graph on the S&P 500 below, stocks had already soared leading up to the election. After the election, stocks were range-bound till April 1, 1981. Stocks then started a slow decline of 19.8% till mid-1982. In the November 2017 election, stocks soared for about four months, were range-bound for about a month, and could start a slow decline starting around April 1, 2017.

Source: Google Finance

Trump and Reagan share many similarities. In the weeks before the election, Reagan trailed Jimmy Carter in most polls, and was losing 47% to 39% by one poll on October 26, 1980. Reagan's platform called for cutting taxes to boost economic growth, using tariffs to protect American jobs (but supporting free trade), and cutting regulations to decrease the size of government. Does this sound familiar? Reagan, who was originally a Democrat but ran as a Republican, also raised the national debt from $1.1 trillion to $2.7 trillion and crafted NAFTA (North American Free Trade Agreement), which was signed into law by Bush and ratified by Clinton. He opposed the Voting Rights Act, but extended it after pressure from Grass Roots. He also pledged to abolish the Department of Education, but he "did not pursue that goal as President." Trump, who originally supported many Democratic policies but ran as a Republican, may also double the deficit and fail to pass many of his campaign promises. A draft for renegotiating NAFTA seems to point that Trump now only wants to make small changes to the treaty. And when it starts to look like Trump will double the deficit and fail to pass many of his campaign promises, the Trump Rally would be erased, just like how the above technicals for the Dow and S&P 500 show.

If Trump gets impeached, gets acquitted, or resigns due to investigations into his Russian ties and other legal issues including a lawsuit, which is a big IF, what will happen to the stock market? There has been only one impeachment in U.S. history, the February 24, 1868, impeachment of Andrew Johnson. Bill Clinton was acquitted on December 19, 1998, since the Senate could not reach the required votes to impeach him. The August 8, 1974, resignation of Richard Nixon was technically not an impeachment, but it was very close. The Dow Jones and S&P 500 started in 1896 and 1957, respectively, so there is no stock data for the impeachment of Andrew Johnson. The S&P 500 fell 16.4% in the months before the resignation of Richard Nixon, and fell another 23.6% before bottoming. The S&P 500 fell 19.3% from July-September of 1998 before bottoming and then surging 19.4% the months before the acquittal of Bill Clinton. Thus, if impeachment, acquittal, or resignation appears close to happening, investors can expect a decline of about 16-19%.

Source: Created from Stock Data

Besides Trump, the seasonal "sell in May and go away" is coming up. The phrase refers to the seasonal pattern that stocks perform statistically worse from May 1-October 31 than from November 1-April 30. This could be caused by an annual slowdown in business activity, such as how companies would tend to buy up semiconductors for Christmas season, and then since they would have excess inventory after Christmas, they would buy less semiconductors till the next cycle. The pattern could also be caused by people selling stocks to pay for summer vacations. The investment strategy is based solely on statistics and has worked 86% of the time for the Dow since 1950. "On average, stock returns are about 10 percentage points higher in November-April half-year periods than in May-October half-year periods." But like any strategy, there are a few cases where the strategy did not work. Further, the S&P 500 yielded a cumulative annualized return of about 11.5% assuming dividend reinvestment since 1980, but moving to cash on May 1 of each year and then re-entering the market on November 1 would have only yielded an annualized return of about 8.5%. And only mid-term election years since 1950 have "an average decline in the May 1-October 31 period, with an average decline of 0.37%." Based on the S&P 500's monthly returns, it does look like November-April performs better than May-October. In the latter period, there were two months with average negative performance vs. one month with average negative performance. It seems that even if the market rises or falls from May-October, it will end the period nearly flat or slightly negative. A more effective strategy may be to avoid the months of February, May, and September and maybe October.

Source: Business Insider

Fellow Seeking Alpha contributor Fortune Teller briefly mentioned the "sell in May and go away" pattern and highlighted key events that could cause the market to fall. He also emphasized that the Shiller PE Ratio shows that the current bull market is one of "the most expensive in history."

Source: Shiller PE Ratio

As can be seen, the ratio is just slightly below where it was on Black Tuesday just before the Great Depression. It is interesting that when researching the Crash of 1929, I concluded that large influxes of capital by banks and billionaires in an attempt to stabilize the market just made the matter worse. That makes me think that the more the Chinese government floods capital into its market to stabilize it, the worse it may get. If a depression hits China, ripple effects would be felt around the world. The United States may have also come very close to another Great Depression if the country continued QE (quantitative easing). Thus, I think it would be wise to not trigger QE4.

But I would argue that a U.S. recession is possible in the near future. A recession is defined as two consecutive quarters of negative GDP growth. The last recession was in 2009, and the nation has averaged a recession every 5 years since 1929 with an average GDP contraction of 2.7%. Fourth quarter GDP growth came in at 2.1%. Estimates for first quarter GDP growth fell to 0.9% as of March 31. If the pace of declining GDP growth continues, GDP growth could hit negative like in the first quarter of 2008, 2011, and 2014. Since the pattern seems to be every three years, could GDP growth fall below zero in the first quarter of 2017?

Source: U.S. GDP Growth Rate

And from the chart below, the market seems overdone for a decline. The amount of time since the last pullback has exceeded the average frequency for a 5%, 10%, 15%, and 20% decline.

Source: Past Market Declines

Three other big issues to watch include the debt limit, the ongoing Greek Crisis, and stock/bond yields. The debt limit was breached on March 15, 2017, but the Treasury can use "extraordinary measures" until mid-2017 to keep the country from defaulting on its debt. The 2011 government shutdown and possible default lowered the country's credit rating and caused a 16.5% decline in the S&P 500. While French elections could lead to another Brexit moment, Brexit caused a short-lived 5% dip in stocks. The bigger issue seems to be the ongoing Greek Crisis. More than $2.2 billion is due in July. The 2015 Greek debt fight likely caused the first of two 10-15% dips in the S&P 500. And on March 19, the Wall Street Journal warned, "At 2.50%, the yield on the 10-year U.S. Treasury note on Friday exceeded the 1.91% dividend yield on the S&P 500." Could investors start moving money into bonds?

Conclusion:

It seems that investors could expect a 10-15% decline, but a 20% decline seems possible. As I mentioned before, accumulating cash and/or buying gold (NYSEARCA:GLD) may be a good hedge against a decline, that way an investor would have enough cash to buy stocks at their lows.

Disclosure: I am/we are long SBGL, DRD.

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.