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Issue 44 • September 23, 2009 Three Caution Flags to Watch for a Market Correction
However, since the market has continued to sail even higher this month — it’s sixth straight monthly gain since March — it’s worth taking another look at where we are in this historic market rally ... and what could signal trouble on the horizon! In my previous article, I said “for every action, there is an equal and opposite reaction.” This is a physical law of the universe that can also applies to financial markets. Some investors call this “reversion to the mean,” which, simply stated, means that extreme market moves in one direction are often followed by equally extreme moves in the opposite direction. The great bear market of 2007-08, followed by a robust bullish bounce that has continued since March of this year, is a perfect case in point. I’m hearing a lot today about how “overbought” the stock market is, and there’s a lot of truth to that. In fact, the S&P 500 Index is trading about 20% above its 200-day moving average of prices ... the first time that’s happened in nearly 30 years ... since 1983 to be exact.2 The magnitude of this rebound has been extraordinary and it’s true that stocks are extended a long way above average, but consider the extraordinary depths from which they came… The Most Extreme Market Swing in Over 70 YearsAfter the Lehman bankruptcy and other high-profile financial failures in the fall of 2008, the S&P 500 closed almost 40% BELOW its 200-day moving average in November.3 The last time that happened was during the Great Depression — over 70-years ago! So, in a sense, we’ve just come full circle. An extreme market panic decline from November 2008 to March 2009 followed by an equally extreme rally phase since then ... all within the span of about 200 days ... a remarkably swift reversal of fortune! Take a look at the chart below for a long-term perspective and you’ll see that such extreme volatility is indeed a rare event.
In fact, since 1950, there have been only 13 times when stocks got as close to being over-bought as they are right now ... a small number of occasions over the past half century. There are even fewer instances when stocks sold off to such extreme levels as they did last year.4 Now, you may be thinking, “that’s an interesting history lesson, but more important, what does it tell us about market conditions today?” Well, if history is our guide, then we could be in for at least a near-term pause in the present rally. In the 13 other periods when the S&P 500 Index approached such over-bought levels — at or near 20% ABOVE the 200-day moving average — stocks declined -1%, on average, over the next month ... and fell about -1.4% over the next three months ... But then the market caught a second wind … and six months after such over-bought readings, the S&P 500 was up about +3.4% on average.5 The Pause That Refreshes?The recent contraction has been dubbed “The Great Recession.” That’s because, while the economic data hasn’t been quite as bleak as the original Great Depression, in many ways it has been the most severe contraction to impact our economy since the 1930s. The second-most severe slump occurred in the mid 1970s — after the Arab oil embargo sent inflation soaring into the double digits. This triggered a severe bear market in 1973-74, when the S&P 500 plunged more than -44% peak-to-trough ... similar to the decline from the 2007 peak to the March low this year. Then, in a quick about face, stocks soared +54% higher in just nine months ... again, similar to the current rally.6 What happened next? In 1975, over-bought stock market conditions finally gave way to a correction of about -15%. This proved to be only a corrective pause that refreshed the market for further gains in 1976, but the good times didn’t last. Another bear market was just around the corner, which took the S&P down nearly -20% in 1977.7 The message from this market history lesson: Extreme moves in stocks can frequently produce extreme, and often unexpected, moves in the opposite direction. Remember, stocks don’t just move up — or DOWN — in a straight line. So, be wary! When the gild comes off this government-induced financial rebound, markets are likely to pause at the least, and at the worst, plunge. The Here and Now — Three Caution Flags WavingRight now, the S&P 500 sits about 55% above its March low. Stocks are extremely over-bought, as measured by the huge gap between the index and its 200-day moving average and a host of other technical indicators we follow at Weiss. Stocks have regained nearly HALF the value lost since the October 2007 high, when the bear market began. This is very similar to the magnitude and duration of the sell off and rebound rally of 1973-74. If we continue to follow this “script,” then it’s reasonable to expect that a correction of 15% to 20% could come at any time. What could signal such a decline? Here are a few of the yellow caution flags I’m on the lookout for right now:
Here’s a key indicator to watch: Since early August, over 90% of S&P 500 stocks have been trading above their 50-day moving averages. That’s over-bought, but such conditions can persist longer than you might expect.8 On the other hand, if this number begins to fall rapidly … below 80% or 70% ... it could signal the beginning of a correction ... which is exactly what happened in June and July of this year!
That’s a 2-to-1 ratio of bulls over bears, which is considered a negative sentiment signal from a contrarian perspective — because if the majority of investors are already bullish, then who’s left to buy? Not corporate executives, that’s for sure ... in fact, insiders at American companies are SELLING stocks like there’s no tomorrow — cashing in on the market’s big rally this summer. In August alone there were $31 worth of insider stock SALES for every $1 of insider buying ... a huge disparity.10 As one wise market researcher says: “Insiders know better than you and me. If prices are too high, they sell.”11 Caution Flag #3. Market Leadership: Since the rally began, two market segments in particular have really taken-off and have led the broad market higher ... China and Technology.
The result: China’s mainland Shanghai Composite Index soared over +100% from November to August ... BUT since then, shares suffered a sharp decline of -23% in just four weeks.12 Technically, that’s the definition of a new bear market in Chinese stocks. In recent weeks, Shanghai shares have bounced back a bit, but the near-term trend is still unclear. Further decline could be a BIG red flag for our markets … Likewise, technology has been one of the BEST performing U.S. stock sectors since the rally began in March 2009. In fact, technology shares hit only marginal new lows in March — just slightly lower than November 2008 — outperforming most other groups.
This drop in relative strength for tech stocks compared to the broad market is yet another caution flag to keep an eye on. The Weiss investment team and I will be watching these three caution flags carefully, along with many other indicators, as we move into the fourth quarter. Should any of these data points deteriorate further, it may provide an early warning of a correction coming in the stock market. Our expectations: After such a significant rally, don’t be surprised to see a correction of 15% to 20% or more in the S&P 500. Such a correction could take the index down quickly to the 850 to 900 range, offering a much better potential entry point for side-lined investors. Stay tuned. Good investing!
1 Bloomberg: Stocks Decline, Trimming S&P 500’s Sixth Straight Monthly Gain, 8/31/09 Disclaimers: 1. Weiss Advice is a publication of Weiss Capital Management, an SEC Registered Investment Adviser. Weiss Research is a separate, but affiliated publishing company. Both entities are owned by Weiss Group, LLC. 2. "Weiss Advice" is published for general information and educational purposes only and should not be construed as a specific recommendation to buy or sell any security. Specific recommendations can only be given to advisory clients of Weiss Capital Management, with the benefit of knowing their financial condition and suitability. Receipt of this publication should not be construed as a solicitation to do business outside the jurisdiction for which the Firm is approved. Currently, Weiss Capital Management offers investment advisory services to individuals maintaining legal residency within the United States. For details, please contact the Firm. View Weiss Capital Management's Privacy Policy. To make sure you don't miss our urgent updates, add Weiss Advice to your address book. Just follow these simple steps. |
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Caution Flag #1. Market Breadth: So far, the rally to new highs in September HAS been confirmed by numerous advancing stocks, with an expanding number of new highs compared to shares that are lagging. But keep a sharp eye out for a reversal. 
Caution Flag #2. Market Sentiment: The Investors Intelligence survey shows bullish sentiment at nearly 50%, while the number of bears in hibernation has fallen to just over 24%.
Chinese stocks actually bottomed in November 2008, about five months ahead of the S&P 500 Index. The reason: Fiscal and monetary stimulus efforts were unleashed in China with full force last year ... while a lame-duck Congress in the U.S. argued over similar measures.
But since late July, while the S&P 500 surged +12% higher, tech stocks gained only +8%.
