Stocks Heading Toward A Healthy Cleanse

money mazeMy Comments: My thinking about a market crash is evolving. I think it’s much closer than it was six months ago. I think it will be relatively short lived. I don’t expect it to be as deep as the one that happened in 2008-2009. But it will happen, and for some of us, it will be painful.

by Eric Parnell, CFA | October 14, 2016

The stock market needs a good cleanse. A solid correction is just what the doctor ordered in working the market back toward some semblance of true fundamental health.

Many signs suggest that such a cleanse could begin to take place at any time now.

Any potential cleanse should be view with opportunity through the start of next year.

The stock market needs a good cleanse. Having become chock full of all sorts of toxins since the calming of the financial crisis so many years ago, a solid correction is just what the doctor ordered in working the market back toward some semblance of true fundamental health. Many signs suggest that such a cleanse could begin to take place at any time now.

In fact, one is long overdue. And for investors focusing on the short-term time horizon, any such stock market cleanse that begins to unfold in the coming week should be viewed as a potentially attractive buying opportunity for holding periods through the start of next year.

Feeling Sluggish
The U.S. stock market has been stuck in a sluggish trading range for far too long now. Despite all of the talk of new all-time highs, the S&P 500 Index (NYSEARCA:SPY) has effectively gone nowhere for the last two years since the end of QE3 in late 2014.

Along the way, it has endured a few corrections that have been unsettling for investors already fidgety about the fact that U.S. stocks are trading at historically high valuations and steadily declining earnings at a time when stock markets around the rest of the world have given way to the downside a long time ago now. In short, it has been a long and sleepless road over the past two years in generating flat-to-low single-digit returns at best on the headline benchmark U.S. stock index.

Nevertheless, the S&P 500 Index remains the leading major stock market on the planet given that supposedly there is no alternative (TINA) to owning U.S. large cap stocks. Thus, it is worthwhile to consider where we stand today and where we are likely to go next.

Put simply, the setup is hardly bullish for the S&P 500 Index as we progress through the final quarter of 2016.

First, the corporate earnings situation remains deeply challenged. The earnings outlook is critically important to the stock market, for it is the “E” in the all-important “P/E ratio.” Thus, if the “E” is shrinking, the stocks that investors own become increasingly more expensive even if the price is grinding nowhere. And such has been the case over the past two years since corporate earnings peaked in 2014 Q3, which is not coincidentally at the start of this sideways grinding period.

Indeed, while corporate earnings are expected to deteriorate even further for Q3 on an annual basis once the final numbers from the quarterly earnings season have been tallied, they are expected to gradually improve in the coming quarters thanks in large part to the gaping profit holes caused by the massive drop in oil prices back in 2014 and 2015 begin to roll off. But with stocks trading at historically high valuations at present, even an unlikely robust corporate earnings recovery will do little in bringing current valuations down from nosebleed levels.

Also, the technical outlook for the S&P 500 Index is looking increasingly like a market that is breaking down. At the moment, the S&P 500 is continuing to hold support at its previous all-time highs of 2134.72, but it has been increasingly testing this support level over the past month as well as the level below it at 2116.48 on the S&P 500 Index.

Given such a soft breakout induced almost purely by the post ‘Brexit’ euphoria in early July (huh? Sounds like something only liquidity-spraying central bankers could cook up), the fact that stocks are already repeatedly testing these previous resistance, now support levels is a bad sign for the ability of stocks to continue holding their ground.

Focusing in on the red box in the chart above, we see that a number of key technical readings are presenting a market that is increasingly wearing down. The S&P 500 Index has been steadily setting a sequence of lower highs since mid-August. And on Thursday, it managed to touch a lower low on an intraday basis for the first time since early September.

Over this same time period, the relative strength of the S&P 500 Index has been on the wane. Over the past month plus since early September, relative strength also switched over from consistently bullish readings steadily over 50 to bearish readings below 50.

Adding to the concern is the fact that momentum has been on a steady ski slope downward from strongly positive readings on the MACD in the immediate aftermath of ‘Brexit’ in early July to consistently in negative territory over the past month.

At the same time, money flow has been consistently fading from strongly positive readings in late July to marginally negative and trending lower today.

Time For A Detoxifying Cleanse

So the market appears to be heading toward a correction. But the first point to mention is the following. Just because it looks like the S&P 500 Index is headed toward correcting does not mean that it actually will. A characteristic that has repeatedly defined the post crisis U.S. stock market is that just as it looks like the bottom is about to go out from under the S&P 500, it somehow manages to find its footing time and time again to rally its way back higher.

As a result, we should not be surprised if we suddenly see the stock market regain its vigor once again and push its way back to the upside. After all, U.S. stocks had many of the makings of a market that was ready to fall into correction in August and September, yet here we are today still grinding along.

But suppose we do fall into cleansing period sometime over the next few weeks. What, if anything, should investors do about it? What magnitude of a correction should we expect? And how long is it likely to last before we see some relief?

In order to answer this question, it is worthwhile to reflect back on the stock market dating back over the past decade, nearly all of which includes the financial crisis period and its aftermath. In each of the past nine years, through both good years and bad, we have seen at least one correction of -5% or more take place during the period from August to December with the magnitude of the average correction coming in at around -10% excluding the fall of 2008.

Thus, a correction in the -5% to -12% range should not be ruled out in the next few weeks. It should be noted that at present, the S&P 500 Index is currently -2.5% below its recent highs, so today’s market would already have at least some of any potential near-term correction already baked in.

What is the most likely correction magnitude in the short term? Something in the -6% to -7% range overall should be considered likely. For a correction of this magnitude would bring the S&P 500 Index back to both its 200-day and 400-day moving averages, which is likely to provide support on any initial corrective move lower. Moreover, a correction in the range of -7% has historically been the pain threshold at which the U.S. Federal Reserve typically begins to relent with soothing words about backing off on any monetary tightening in the near term.

And given that the Fed has conditioned the markets to think that it will be raising interest rates in December, it is already armed and ready with the policy concession of backing off on this rate hike to get the U.S. stock market back into good cheer again.

And if such a correction were to unfold, exactly how long should we expect it to last? August to December corrections in recent history have tended to be sharper and shorter. And given that we are already late in the year in mid-October, it is likely that any correction that were to unfold over the next few weeks would likely be swift, which could end up being unsettling to investors, many of which may already be braced for the “big one” where the stock market finally falls and does not come back.

But for as prone as the market is to corrections during this time of year, so too is it inclined toward bouncing strongly following these sharp corrections. For example, the average rebound following these corrections over the past decade has been +12.6%. And the sharper the market corrects, the more meaningful the subsequent bounce higher. This even includes the period in 2008, as stocks rallied by +27% from mid-November through early January following the dramatic declines that came before in October and early November.

Seek To Benefit From Any Purifying Stock Market Experience

Thus, investors may be well served to actively seek to capitalize on any short-term correction in stocks in the coming weeks. If the correction is shallow – say we only see another -2.5% of downside from here in the next few weeks – expect the subsequent bounce to be shallow. And if the correction is more pronounced – suppose the market pulls back by -6% to -7%, or perhaps even -10% or more – expect the subsequent rally to be more profound.

For while the market may have serious challenges going forward from a long-term fundamental perspective, enough liquidity and policy firepower still exist in the system to restore its verve for a respectable bounce in the short term.

Anticipate that any such post correction bounce could last at least through late December and early January. This may be true even if the Fed does end up raising interest rates by 25 basis points in December. But once we begin to move solidly into the New Year, all subsequent bets about market direction are off, particularly if corporate earnings disappoint expectations between now and then, which is very much a possibility. Put more simply, the potential still looms large over the intermediate term to long term for the onset of a new sustained bear market at some point in time going forward.