A correction in stocks may be indicated

Technicals point to a correction—but it's not totally unexpected.

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Key takeaways

  • The US stock markets have rallied quite a bit since the March low and a correction now seems to be underway. A correction is a short-term stock market drop of about 10% or more.
  • Looking back at the Global Financial Crisis, a correction came in 2009 at a similar point in the recovery.
  • A 10% correction would bring stock valuations back in line with long-term earnings estimates.
  • The economic fundamentals that supported the rally in stocks so far are still there.

Is it time for the recent rising market to take a rest? It's starting to look that way with the S&P 500 (SPX) down nearly 6% from this week's high, as of mid-day Thursday. As of this week's high of 3,233, the SPX appears to have mapped out a textbook 5-wave advance. The chart below shows that wave 5 equals wave 1, and waves 2 and 4 retraced a similar amount of waves 1 and 3 (37%-43%).

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.

The good news is that 5 wave patterns are considered primary waves, which is a fancy way of saying that the correction that follows is usually just that: a correction. Support is around 2,950, which is the top of wave 3.

By definition, a correction is a drop in the market of about 10% or more. Corrections tend to be short-lived—unlike bear markets which can be protracted periods of decline.

The notion that the market needs a rest is supported by the 2009 bull market analog below. Back then, following a rally of a similar duration and magnitude, the SPX corrected from June 11 until July 8 (one month).

The decline was 9% after a 44% gain, and it retraced around a quarter of the rally. A similar correction now would take the SPX down to 2,950, in line with the above.

To me, a correction seems entirely plausible (and even welcome), especially now that everyone is on a full “second wave” alert with COVID-19 cases back on the rise in certain states.

Also, we are seeing some rotation in recent days out of the formerly beaten-down cyclicals (which have had quite a run thanks to the new day-trading culture), and back into the secular growers and gold.

One thing I've seen in my charts is the secular growers and gold reasserting their leadership, while energy and the banks take a breather. This rotation comes after a very good run with broadening technicals—75% of the market is now at new 4-week highs. Over the past 4 weeks or so, we've seen broad-based gains. If we are heading into another correction/consolidation phase, then I would expect the leadership to rotate back to what we saw during the first few weeks of May.

Fundamentally, with the SPX having recently rallied to within a 6% drawdown from the highs while the longer-dated earnings projections remain at −14%, a 10% correction would bring us back in line with those estimates.

That would also bring the forward P/E back in line with where valuations were at the peak. They are now about 1–2 points above. The caveat, of course, is that we don't have any good visibility of where 2022 earnings will be. Oftentimes those estimates are too high, although following bear markets they are often too low. We just don't know right now.

Bond yields, the dollar, EM, and commodities

Meanwhile, bond yields are declining a bit following their decent ramp higher. With the Fed committing to no rate hikes until at least 2022, and the sector rotation going from the financials back to utilities, perhaps yields will remain below 1% for the time being.

  • The dollar remains in a now well-established downtrend, which, I think, bodes well for the market in general and non-US markets in particular.
  • There are no signs of rotation in emerging markets.
  • And commodities continue to impress, with copper on the rise.

What does it all mean?

All this suggests to me that whatever correction we may see in the coming weeks will be just that. Corrections tend to be shorter and shallower than bear markets. With the uncertain path of the virus and the fragile economic recovery, bouts of volatility may continue to be likely. At least, the global money supply remains up and, especially after yesterday's Federal Open Market Committee (FOMC) meeting, there are no signs that any of this is about to change.

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