How close is the S&P 500 to a level that you should REALLY start to worry?

November 13, 2018

How close is the S&P 500 to a level that you should REALLY start to worry?

If you were watching the market sell off again yesterday, you probably started to wonder as I did if the market was really starting to follow through on the bearish sentiment that drove it back into correction territory for the Dow and the NASDAQ. The S&P plunged nearly 2% amid worries that the entire tech sector, which has paced and even led the market throughout its bullish trend since 2009, has finally peaked. The “FANG” stocks – Facebook, Apple, Netflix and Alphabet, and Amazon – all led the selloff as reports indicated that demand for Apple’s (AAPL) iPhone has weakened.

If you’re listening to the talking heads on market media outlets, it’s even easier to buy into the negative hype, as more and more of them wring their hands and talk about the end of the bull market. The to remember, however is that while a correction always precedes a legitimate bear market, not all corrections are followed by a bear market. In fact, corrections are entirely normal, and even healthy; they are one of the things that makes a long-term upward trend sustainable. During its nearly ten-year bullish run since 2009, the stock market has experienced numerous pullbacks and corrections.



Does that mean that all of the angst, worry and concern is overblown? I’m not sure; the truth is that the longer the market holds an upward trend, the greater the major trend reversal risk becomes. The truth is that when the market’s long-term upward trend does finally reverse – and make no mistake, it certainly will – the drop is likely to be extreme. First, consider that since bottoming in late 2009, the S&P 500 has more than quadrupled value; next, consider that in the last two bear markets, from 2008 to 2009 and prior to that, from 2000 to 2002, the downward trend shaved 50% or more from that index each time. As of yesterday’s close, the S&P 500 closed a little above 2,700 with its all-time high in late September coming at around 2,900; that means that if the market is actually starting the latest, inevitable slide to bear market territory, the bottom might not be seen until the index is around 1,400, or even lower.

I think the real question isn’t if the market is going to reverse; it isn’t even when, despite the talk that seems to be dominating market news right now. Even the question of why or how it could happen is less important at the moment than identifying the point that I think every smart investor should be ready to acknowledge the reversal could actually be happening.

Analysts like to use percentage declines as a barometer for how severe the latest drop from a high is. 10% is generally accepted as the level at which the market is officially in a corrective phase. The market’s drop in October put things in the second corrective phase of the year. Where is does the bear market come to play? The next percentage level is 20% – which for the S&P 500 would be around 2,300 based on its September highs. We’re still more than 400 points away from that point, which is why you might see some analysts maintaining their generally bullish stance right now.



I like to use trend and pivot analysis on the broad market to supplement these generally accepted levels. I think the market is closer to a legitimate bearish signal than the 20% minimum suggests, and it is another reason a lot of people are wringing their hands right now. Here is what I’m seeing right now.

 

This chart is for the S&P 500 SPDR (SPY), the ETF that matches the movement of the index. The prices shown on the right for the stock don’t equate directly to the S&P 500, but the percentages between prices are consistent, so this is a good proxy chart for the index. I’ve drawn a horizontal red line along the bottom of the chart using the previous low points the S&P 500 tested during the first correction of the year. That levels corresponds roughly with the 2,600 level for the index; as of yesterday’s close the market is a little less than 5.5% above that point. It came near to that point in October before rallying strongly towards the last couple of days and into the beginning of November.



This red line is what I think most investors should be treating as the signal point; not necessarily for the point where the market has finally turned to bear market conditions, but rather the point where the market can actually confirm a legitimate downward trend. We’re not quite there, although the drop from the market’s pivot high a few days ago is a warning sign. If the index drops below its October pivot low, the market will officially be in a short-term downward trend. If that is then followed by a drop below the red line I’ve drawn, I think you’d be smart to say that the downward trend  is more likely to extend into an intermediate time frame, which could last anywhere from just a couple of months to as long as nine months.

An intermediate downward trend doesn’t guarantee the trend will become a long-term one, and it doesn’t guarantee the market will drop into bear market territory; however given how raw the market’s emotional state appears to be right now, I think you would foolish to discount the very real possibility that the market could easily shift from uncertainty into legitimate panic once the market breaks below the 2,600 level. If that panic extends to massive selling, we’ll see a lot of average investors getting out of their positions and you’ll hear even more about concepts like “safe havens” and “flight to quality.” These are market conditions that exist when investors start dumping stocks and moving en masse into instruments like bonds, money markets, and even to cash. That hasn’t happened yet, but pay attention to the 2,600 level for the S&P 500. If the index drops below that level, and stays below it, don’t be surprised if the selling gets even worse. That’s why even as I’m writing about stocks in this space that I think represent interesting values right now, you should be very careful about taking on any new positions. When the sell-off really starts, it will be hard to find a place to hide, which means that you should be holding stocks you’re willing to ride out over the long-term, with conservative positions sizes that make it easier to limit your overall risk even in an extended bear market.