U.S. Equity Markets' Forthcoming 25% Correction

Jul. 31, 2019 3:29 PM ETXLF, SPY, SH55 Comments

Summary

  • Equities are in the topping region and the risk to reward skew now favors the short side.
  • For investors looking to exit equities to re-enter from lower, now is the time. For those looking to hedge long equity exposure, now is the time.
  • Consider your risk exposure and how it relates to your overall tolerance now, and don't wait until markets have dropped 10% to do so.
  • This idea was discussed in more depth with members of my private investing community, The Active Investor. Get started today »

For some months now we have suggested that the US equities markets are topping and will soon embark on a 25-30% overall correction. Despite investors having pushed prices incrementally higher on the notion of continued Federal easing, nothing in our analysis has changed, and our overall downside target levels for the S&P, Dow, and NASDAQ are the same. The only thing that’s changed is that the drop will be from somewhat higher levels, this increasing the magnitude of the drop that will occur.

In this article I will discuss our expectations for both timing and price targets for the S&P 500 and Russell 2000. In addition, I will show our analysis of the Financial Select Sector SPDR Fund (XLF), which has been particularly weak.

If risk exposure is one of your considerations, then now is the time to consider exiting or reducing equity exposure, or minimally hedge. In truth we have been suggesting a topping of the general equity markets since earlier this year, counting the move up from the Christmas low as a retrace against the move down into the Christmas low, and now, with the benefit of hindsight, one could easily argue had they followed our analysis they would have gotten out early and missed this last move higher. My only reaction to this would be to reply by saying “true”. However, I would have to also point out that while equites are somewhat higher than we expected, the downside risk relative to the upside potential did not then, and certainly does not now warrant an over allocation of exposure to general equities. Topping markets are never easy, and always go through a rounding process before downside takes hold, and never announce “this is the top, short now!”. The issue for most investors is that when markets are frothy, as they are right now, they rarely look past the increasing value of their brokerage statement for evidence to suggest they should do otherwise than to simply hold and maintain what is already working quite well. A review or assessment of risk is not even a slight consideration. Most individual investors rarely play the “what if” game, asking themselves the question “what if the market drops 25% or more, how will it affect me financially?” It is not until a significant selloff occurs that most individual investors will take note of the drop, only to then rationalize that equities will come back shortly and offset the loss of real value in their account(S). Then, when b-wave occurs, as shown on the SPX chart below, only to lend to the even larger c-wave drop, there is a period of investor capitulation, or what is commonly referred as the “recognition wave” , where investors exit and drive prices to extreme selloff levels, only to then miss the move up that occurs thereafter. So, the question is do you want to exit early, or do you want to exit late? Some might say “I won’t exit at all”. These are all choices that as investors we can make, however, they need to be done in the context of knowing our own tolerance for the associated value declines inclusive in a large amplitude market. Put simply, will you capitulate or not? The other notable consideration for those of us who are active investors is simply that over the long term we are better off to exit positions and re-enter from lower. The long term effect of exiting in the upper 20% of market movements, and re-entering in the lower 20% over the long term contributes exponentially to long term performance. If this is your posture, then now is the moment to take note, in our opinion.

The continued rise changes nothing in terms of our Fibonnaci price targets to the downside, other than those targets represent a larger percentage decline than they did from lower price levels presented earlier this year.

Please don’t get me wrong, this is not a doomsday forecast, as once this correction completes, we are still expecting a significant new high in equities. The expectation we have for a drop in equities would be more akin to a long overdue recession. In John Hussman’s latest article entitled They’re Running Toward the Fire, he states:

The current market highs are dominated by a single concept: the idea that the Federal Reserve is likely to shift to an easing mode in the months ahead, most likely at its July 30-31 meeting. I don't doubt that prospect at all. The problem, as I observed in my regular July comment, is that with the exceptions of 1967 and 1996, every initial Fed easing (ultimately amounting to a cumulative cut of 0.5% or more, following a period of tightening in excess of 0.5%) has been associated with a U.S. economic recession.

So, with this as the backdrop, allow me to review our expectations. Let us start with the S&P 500, as expressed below by looking at the S&P 500 Emini Futures contract. From an Elliott Wave perspective, we are view this current topping region as the completion of Primary Degree wave (3), or what is shown on this Daily ES chart as the green wave (3). This then sets up a pull back for Primary Degree wave (4) to the 2300 – 1850 regions. We do not expect the initial drop to take out upper support, which is in the 2,654 – 2,471 regions before a larger bounce would occur. If the SPX takes this level out on the first move down, it would be not change our level expectation, but would suggest an alternative Elliott Wave count.

We use Hurst Cycles timing models in concert with our Elliott Wave and Fibonnaci levels. Hurst provides us a solid sense of timing, but fails to provide adequate price level expectations. Elliott wave and Fibonnaci levels provide price level expectations, but are frankly terrible at providing timing expectations. The combination of both provides for incredibly accurate analysis, and then when combines provides investors very tradeable mores, both long and short.

Hurst timing suggests an initial move down into late August, 2019, followed by a bounce into late September, followed by an 18 month cycle low to occur into late October to early November, 2019. This is what we show here as the initial ABC, collectively the initial (A) wave. A reasonably good sized bounce would then occur in to early 2020, followed by the much larger C-wave to occur into the April to May time frame in 2020.

S&P 500 Emini Futures Contract Daily Chart

Daily ES chartNext, let’s take a look at the RUT – Russell 2000 Index. The most notable observation is that the RUT is ahead of the SPX in its pattern. It seems evident that disintermediation from those exiting higher beta in favor of lower beta, higher quality stocks have depressed the pricing of the RUT coincident to driving the SPX and Dow to new highs. This is only one more piece of anecdotal evidence that supports that a reasonable drop is imminent in equity markets.

Russell 2000 Index Weekly Chart

RUT Weekly ChartAnother very weak sector has been the Financial Select Sector SPDR Fund (XLF) – see the XLF Daily Chart below. While the SPX has made new highs, the XLF is still below the high it established in early 2018, and still significantly below the high that was established in advance of the drop in equities that occurred into 2009.

Financial Select Sector SPDR Fund (XLF)

XLF Daily Chart

Also note that while the Dow and SPX have made new highs, the Dow Transports are diverging by not making new highs.

In conclusion, we are expecting a 25-30% overall pull back in equities from current levels. For those investors who like to exit equities and re-enter from lower, this is a favorable time to do so. For those who hedge, this is a good area to consider putting on hedge exposure. For those opportunists and active investors, this is a reasonable area to build short exposure.

For additional comments on our expectations discussed herein, please refer to US Equity Market's Forthcoming 25% Correction - Part 2.

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This article was written by

Brian Fletcher profile picture
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We give actionable entries and exits to maximize profits with minimal risk

Brian Fletcher is the Manager of Abaci Capital Advisors, which is a registered investment advisory firm that manages capital for qualified investors, and which focuses on achieving consistently out sized non-correlated annual returns in a host of investment sectors. Through the practical delivery of investment opportunities for managed investor accounts, Brian provides investors what he calls “super-performance”, enabling those who prefer to not trade their own capital the ability to allocate to a managed account structure that follows a highly risk managed approach to achieving annual performance.


Brian is also a the manage of The Active Investor service here on Seeking Alpha, and is a Senior Research Analyst for TimePriceAnalysis.com, where he manages the Strategic Miners Portfolio. Brian uses technical analysis to determine undervalued sectors, and then implements a combination of fundamental and technical analysis to pinpoint specific “value” opportunities within the identified sector.


Prior to forming Abaci Capital Advisors, LLC, Brian served as CEO for Cox Technologies, Inc. Through his investing career, For many years Brian has focused heavily in the analysis and purchase of undervalued bank stocks from within the candidate rich US Banking Industry. Because of his industry knowledge, he has served as a board of director for two North Carolina banks.


Brian received a BSBA in Finance and Economics from Rockhurst University, holds a Series 6 license, and is a licensed Commodity Trading Advisor through the National Futures Association.


Disclosure: I am/we are long SDS. 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.

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