Does the S&P500 Need a Catalyst to Spark a Correction?

Here we go again. Like clockwork, the S&P500 advanced another week. This time it added about 0.9%, on top of record high levels reached the week before. Volume was modest. And volatility was almost non-existent; the VIX index ended the week once again below the 10 level, a level rarely reached over the last 20 years.

In terms of US macro news, the results were mixed last week. In the JOLTS survey, job openings missed. Producer prices, both headline and core, came in hotter than expected. So there’s more upstream inflation than economists had anticipated. Consumer prices, on the other hand, met expectations; core CPI, however, came in lower than expected. So there’s little evidence of downstream inflation heating up. PMI composite flash came in weaker than expected, and industrial expectations also missed. On the positive side, initial jobless claims were better than predicted; they’re now lower than they’ve been in decades. And retail sales also beat consensus estimates.

In terms of technical analysis, the over-stretched condition in the S&P500 just keeps on getting more distorted, ie. over-stretched. On a monthly basis, prices have now deviated from the two-year moving average by a large percentage than they did near the peak of the 2000 tech bubble. Prices on this measure are so stretched that it would take a roughly 15% correction to just bring them back to this super long-term moving average. Keep in mind, this type of correction would not even break the uptrend. In other words, even if a 15% correction materialized, many technicians would argue that the bull market cycle would still be in effect! It would take a far larger drop to break this bull cycle.

So many market analysts are asking—exactly what type of catalyst would be needed to spark such a larger correction, a correction that has ended every bull market cycle in the history of US equity markets?

And surprisingly, given today’s market action, more and more analysts—analysts who should know better—are starting to argue that with the Federal Reserve supporting US risk asset markets with current and with potential monetary easing, that for the first time in US financial market history, US stock market investors should not worry about any major correction. Instead, they should continue to confidently buy every minor dip….and continue “making money” year in and year out with US equity markets.

These analysts argue that even if some sort of huge catalyst were to appear—think war with North Korea—that the Fed would simply open up the monetary firehose and push prices right back up to where they were…and then even higher to new all-time record highs.

In short, according to the new conventional wisdom, stocks cannot go down. And if they even so much as suffer a hiccup then the wise investor should be thankful for the short-term “sale” and just buy more.

The problem with this thinking is that many analysts assume that some sort of big catalyst would be needed to start—even if temporarily—a US stock market decline. What if the fundamental reason for the future decline is simply a matter of obscene valuation?  If the Shiller P/E of the S&P500 reaches say 30, then will it be the fault of some war (against North Korea, or anyone else) that really causes the S&P500 to fall by more than 15%?  Or will it be the fact that investors collectively pushed the S&P500 to obscenely high valuations …..and that a trigger, ANY trigger, was all that was needed to create fear among investors who would collectively….yet unsuccessfully….all rush for the exits?

Given the fact that a huge percentage of today’s traders are too young to have ever experienced a bear market, and given the fact that in risk asset markets in general, all investors tend to forget the lessons—and losses—of the past because they’re too absorbed with the paper gains of the present, it’s very likely that when the next bear market finally arrives….and it will….that the cited “catalyst” for the correction will only be a diversion, an excuse, for what only a few long-term investors will rightfully point out to have been the cause—excessive valuation that was reversed by a collective change in market psychology, a psychology emphasizing greed that suddenly shifted to a psychology of fear.

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