MW Five reasons we're headed for a 10% stock-market correction - or worse
Michael Brush
Summer is winding down, and 'spooky season' will soon be upon us. That's just one cause for investor wariness.
Shown: Halloween items on display last week at a wholesale warehouse in Alhambra, Calif.
Stock-market weakness over several recent trading days, with the major benchmarks losing ground in three straight sessions through Tuesday, may represent more than just normal volatility. It could be a sign of bigger trouble ahead - like a possible 10% to 20% market pullback.
Here are five reasons for that, and what you should do to prepare.
'Spooky season' is just around the corner: September is typically the worst month for the S&P 500. On average since 1928 it has fallen about 1%, as this chart from Yardeni Research shows. That 1% seems innocuous, but September is the weakest month because so many more serious pullbacks happen then.
While October has a stronger finish on average, typically the low for the year happens around Oct. 10-12.
Investor sentiment is very bullish: This is a negative in the contrarian sense, since it often pays to do the opposite of the crowd in the stock market. Besides, when so many investors are bullish, there are fewer people on the sidelines to buy stocks and push them higher.
My favorite sentiment indicator, the Investors Intelligence Bull/Bear ratio, recently came in at 3.88 on a de facto scale of around 0.5 to 5. Readings above 4 historically suggest it is time for caution in the stock market. We are close.
Next, several market internals point to excessive bullishness, notes Jim Paulsen, the economist and former Wall Street strategist who writes Paulsen Perspectives on Substack. Here is a roundup.
-- Both the price and earnings per share of the S&P 500 index SPX were recently near or at record highs relative to their trend lines. This suggests they can't go much higher, in terms of deviation above trend.
The S&P 500 recently traded 55% percent above its postwar trend-line average. The only time the price premium was higher was at the very top of the tech bubble that burst in March 2000. S&P 500 EPS was recently at extreme highs relative to trend.
"There simply is not much room for either stock prices or EPS to continue rising without some correction or a pause which allows the trendline averages to catch up," Paulsen contends.
-- Defensive stocks are unloved. The S&P 500 defensive stock market capitalization has fallen to 17% of total S&P 500 market cap, close to a record low. "Defensiveness in the U.S. stock market has seemingly gone AWOL," says Paulsen. "Most investors are still more worried about missing out on the next leg of this New Era bull run [than] they are about suffering any major stock market setback."
-- Finally, a Bank of America bull-and-bear measure recently stood at 9.6 on a scale of 10. This represents extreme bullishness, which makes it a sell signal. This gauge measures factors like hedge-fund positioning, cash levels among portfolio managers, money flows into stocks versus bonds and credit-market technicals.
Wall Street equity analysts are exuberant: Bulls argue that recent stock gains are justified by earnings-growth momentum, which has indeed been robust. However, a lot of gains in any market are based in expected earnings growth. Here we see signs of extreme bullishness, too, which might be a negative in the contrarian sense.
The 12-month forward consensus S&P 500 EPS estimate is nearly 90% above the trailing 10-year average reported EPS. On average, the premium since 1990 is only 32%, notes Paulsen.
"Historically, lofty long-term growth expectations have been a bearish setup, negatively correlated with future equity returns," agrees Savita Subramanian, the head of U.S. Equity & Quantitative Strategy at Bank of America. B. of A. says history suggests the current long-term growth forecast suggests 7% downside risk for the S&P 500 over the next 12 months.
The economy may soon start surprising to the downside: That's because several forces have been putting downward pressure on growth. Paulsen cites the strong dollar, high oil prices, inflation, the flattening of the yield curve, rising 10-year-note yields (TY00), a declining deficit-to-GDP ratio and a slowdown in money-supply growth. All of these forces suppress growth with a lag of around six to 12 months. They have been in place for a while, and they are kicking in. The Aug. 7 report of an unexpected loss of 23,000 jobs in July might have been the first shot in this trend. Because sentiment is high, investors will be "surprised" and sell when more evidence of weakness emerges.
This chart demonstrates the lagged effect of three of these contractionary forces: dollar strength and rising oil prices and long-bond yields.
Earnings-growth momentum is slowing: EPS estimates are rising at a slower rate than they were three months ago. Since earnings-growth momentum has played such a key role in market gains, this could be an early sign of trouble for stocks.
EPS estimates for the forward, or third, quarter were recently up 0.89%, down from the 1.16% increase in forward estimates following first-quarter reporting. That may seem like a small change, but it's a yellow flag for people who follow these things closely.
"We want you to become slightly more cautious because positive EPS estimate revision momentum has cooled somewhat," Nick Raich of the Earnings Scout wrote in a recent research note.
The good news is that this has to happen for two quarters in a row against rising stock prices for an earnings-momentum slowdown to signal the end of a bull market. "The key from here is whether this slowdown continues," says Raich.
The bottom line
How bad might the near-term damage be? No one knows, but Paulsen throws out an alarming guess: He thinks we might see a 10% to 20% correction. He isn't forecasting outright recession, since household and businesses balance sheets are strong. A recession would spark a prolonged bear market. Instead, he projects "a period of scary recession fears, intense enough to cause an S&P 500 correction and an S&P 500 technology sector bear market before the end of this year."
What to do now
All of this does not mean "sell everything" because a correction might be coming. Exiting and re-entering the stock market around pullbacks is notoriously difficult. I would definitely not sell out of long-term, multiyear positions because of projections of a pullback that may not happen.
Instead, be careful not to chase stocks here. If you trade, consider taking trading profits more quickly than usual. Let cash build up, and be careful about using margin.
This is a "buy weakness" market probably through the middle of October - which, again, typically brings the low for the year in stocks.
-Michael Brush
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