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Could a 10% correction be in the cards?

The S&P 500 has dodged some attempted corrections but that may not last.

  • By Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company (FMRCo),
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Key takeaways

  • Historically, the September-October window has produced some dizzying declines in stocks, and like clockwork the market has started to wobble a bit in recent weeks.
  • What might cause a fall wobble? Catalysts could include the upcoming Fed taper and financial stress in China's property sector. The Delta variant has been a cause for concern as well, but fortunately that wave seems to be cresting now.
  • While the headline market averages have continued to trend higher this year (driven by large-cap growth stocks), when we look under the hood we can see that the broader market has been treading water, in line with past periods when the Fed started to remove liquidity.
  • We'll see if the current wobble turns into an actual 10% correction. If so, it will be important to stay focused on the long-term fundamentals, which remain favorable.

About the expert

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.

There is much to be learned from history and that includes market history, of course. There's a reason we study charts, for they are the collective unconscious of millions of minds (and trillions of dollars) that have gone before us in an attempt to make money grow.

One thing that history teaches us is that some of the scarier declines in the stock market have occurred in the September-October time frame.

That seasonal window is now upon us, and like clockwork the market has been testing its 50-day moving average (MA). Given how many times the S&P 500 has successfully tested this support level over the past year, it wouldn't surprise me if it eventually fails to hold. Perhaps we will see a test of the 200-day moving average in the coming weeks, which would amount to a proper 10% mid-cycle correction.

What could be the catalysts for a 10% correction? The obvious candidates are the upcoming Fed taper and the Evergrande bankruptcy. (Evergrande is a huge, heavily indebted property development and home building company in China.) I had the Delta wave on that list as well, but fortunately it looks like this fourth COVID wave is now peaking in the US. The good news is that the US economy did not lock down (per the Goldman Sachs Effective Lockdown Index), but the flipside is that there may not be that much incremental gain in economic activity on the other side of this wave.

We see from the breadth work that only 44% of stocks are trading above their 50-day average. The peak was at 92% back in March. While the S&P 500 price index has continued to march higher, fueled by the FAANGs (Facebook, Amazon, Apple, Netflix, Google), by this measure we could say that the market has been in a stealth correction for the past 6 months.

From a sentiment angle, we see that close to $1 trillion has flowed into equity funds and ETFs since the pandemic bottom 18 months ago. So perhaps there will be some pent-up selling pressure if the 50-day MA gives way. I will take the other side of that trade.

One "red flag" of sorts is the torrent of new equity issuance in recent months. The number of IPOs is through the roof, as are secondaries. (A secondary offering is the public sale of previously issued securities held by large investors, usually corporations or institutions.) We need to go all the way back to 2000 to get anything close to what we are seeing today.

If there is a correction, then history would tell us that bond yields could decline. Based on the correlation of sector returns to changes in interest rates, that would suggest that growth stocks could continue to lead, even though they have already been doing so in recent months.

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