S&P 500 Correction: How Low Can It Go?

On Monday, I showed the chart below  with the previous week’s close putting the S&P 500 solidly below its 10- and 20-week moving averages (black and blue on the chart, respectively, with the 50-week in green). And after momentum and volatility had come to a virtual standstill, with the market spending two months merely marking time around 1,100, the upside breakout thesis in January became weaker than a faint hope. Finally bears would get their chance as bulls had to lighten their wagons and the market rolled to favor uncertainty and risk aversion.

The key support levels I am watching for the S&P are between 1,020 and 1,030.  The 1,015-mark was a key area of congestion and support in August through early October. Then the late-October/early-November pullback found support in the 1,025-1,030 area. Also, the 200-day moving average comes in around 1,020, a level not breached since the July lows. I think equity bulls will come in above here and buy the market when valuations are irresistible again.

As I outlined in a series of articles last year, The Bull Train You Can’t Catch, we are still in the early innings of this cyclical recovery and equity portfolio managers have to buy stocks at this stage to earn their keep. In early November, I summarized what would drive the S&P back above 1,100 to new highs and gave the Bull Case—5 Reasons to Buy.

So, if I’m still longer-term bullish, what else besides the technical picture above gave me a sell signal a week ago?

Three Fulcrums

1) China Slowdown. Concerned about asset bubbles, the Chinese government has been taking steps to cool things down. This has puts the brakes on many facets of the risk/reflation trade and a global recovery built on the back of emerging market leaders, like the Chinese economy.

2) Sovereign Debt. I began recommending short positions in the euro currency back in early December after Greece was first downgraded. The PIGS were finally coming home to “root” and with that much uncertainty, it’s definitely “sell first, ask questions later.” This fear will certainly spill over into other emerging markets in Asia, Latin America, and Africa.

3) Perfect Future. Stocks have rushed in the past nine months to price in the most optimistic recovery, and in a race where trillions of dollars are chasing a few thousand stocks, the money caught its prey. Now, all those money managers in aggregate get to watch Q4 earnings meet and beat most expectations, and they aren’t disappointed overall. But they might be concerned how sustainable growth rates are into an uncertain first half, especially with pressure on interest rates to rise before employment has rebounded.

How Low Can It Go?

We need a correction. The stock market cannot hang out at 1,100 for three months, and we are not going higher in February. That leaves the correction scenario into March. The fall in June-July of last year was the steepest pullback we’ve had and at only 9%, hardly worthy of the title “correction.”

A good washout to the low 1,000’s on the S&P would give this market the internal structure to rally strongly again and make new highs by summer. And from peak-to-trough (roughly 1,150 to 1,000) would be a 13% correction. I don’t think it will be that severe. Money managers will come in before then to buy the market at 1,040 for the first bounce. Anything below that will be bargains, as long as no other cracks in the global recovery surface.

“Mind the Risk, Bank the Profits!”