The S&P 500 has gone 267 days without a correction of 5% or more. (Hat tip to my fellow Edelson Institute colleague Dave Dutkewych for bringing this to my attention.) That’s its longest winning streak in 20 years.
But this bull market is badly in need of a correction. And a 5% correction may be the best-case scenario for the U.S. averages.
You have to admit: The U.S. economy is touch-and-go. President Trump’s economic agenda is a hope and a prayer at best. And many worry the Federal Reserve is about to trigger a recession if they keep raising interest rates and begin to unwind their balance sheet.
But perhaps the biggest threat to equities right now … is equities themselves.
Return on equity is a measure of the profit that companies make on money invested by shareholders. And ROE is at its lowest since World War II.
Plus, the CBOE Volatility Index (VIX) remains gruelingly low. Same with corporate bond spreads. Each measure suggests investors are complacent about risk.
In addition, share buybacks — the saving grace for share prices when earnings were contracting — decreased 17.5% from a year ago. Either companies don’t feel the need to rescue their share prices anymore, or they are worried about buying at these levels.
Finally, equity market valuations are a concern …
A price-to-earnings ratio (P/E) near 22 is in the top 20% of historical P/E measures. And the Cyclically Adjusted Price-to-Earnings ratio (CAPE) compares stock prices with corporate earnings over the past 10 years.
For U.S. stocks, CAPE stands at 28. This is a level that typically precedes significant market declines and longer-term underperformance.
To say stocks are due for a correction is an understatement of this eight-year bull market.
Sure, there are things the bulls can cite to rationalize higher equity prices. First-quarter earnings season was good, and second-quarter earnings have beaten estimates more than 75% of the time thus far.
Bulls might also point out that cash is plentiful …
According to a measure of M2 global money supply used by JPMorgan, there is $5 trillion of capital sitting on the sidelines waiting to buy stocks.
Add in the common perception that equities are the only game in town, and the prevailing wisdom remains “buy the dip.”
But, for the last 18 months, I’ve been watching a pattern unfold on the S&P 500 …
That 5-wave pattern on the S&P 500 very closely resembles a long-term Dow Jones Industrials bull market from 1932 to 1987. We’re within spitting distance of a critical resistance level — roughly 2,500 — that I identified early last year.
And we’re at a place in the pattern that corresponds with the Dow Industrials’ 16% decline in 1983. Once the dust settled, however, the Dow surged substantially higher until the market collapsed on Black Monday.
This time, when a correction arrives, major averages could fall 5%, 10% or even 16%. That’s why you should protect yourself.
Stop-loss orders are a good idea. And aggressive traders might consider shorting the market by purchasing put options on something like the SPDR S&P 500 ETF (SPY) or the SPDR Dow Jones Industrial Average ETF (DIA).
If options aren’t your thing, you might seek out and buy shares of an inverse ETF such as the ProShares Short S&P 500 ETF (SH).