Lately, on the financial media outlets like Fox Business Network and CNBC, I've been calling for a stock market correction ... not necessarily a new downtrend, but a sizable correction. Why?
Well there are fundamental warning signs that I see and technical warning signs that I see.
For instance, right now, the price-earnings (P/E) ratio, which shows how much you're paying in price relative to the average level of earnings, is getting to elevated levels on the major stock market averages. This means that investors are beginning to pay too much for stocks.
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However, this doesn't mean they have to top out just yet. After all, stocks tend to get to ridiculous extremes before fully topping out and turning into a full-blown downtrend.
For instance, the P/E of the Dow Jones Industrial Average is 16.30. The Standard & Poor's 500 is trading at a P/E of 18, the Nasdaq at 18.25 and some averages like the Dow Transports and Dow Utilities trading at P/Es of 21 and 25, respectively.
Now, let's just back up and take the S&P 500 for instance.
The S&P 500 is trading at a deep value when the index trades at a very low P/E of 6 to 8. It's fairly valued when it's trading at a P/E around 13 to 15, and it's overvalued fundamentally above that level.
When does the S&P 500 tend to run the risk of really crumbling? When it's at a P/E of 20 to 25.
Can it go higher than this? Yes, there have been times where it has. But when it did, the economy was on a much better footing than what it's on right now.
So with the S&P 500 trading at a P/E of 18, which means that investors are willing to pay 18 times the level of average earnings, it's trading too rich.
Therefore, at this point, it's probably best to lighten up some stock positions on rallies higher. It doesn't necessarily mean "go to cash." It just means to realize the market conditions in which you're living and "be ready" for any major changes as they come.
Then there's the technical side of the market.
For starters, we know that this stock rally had absolutely NOTHING to do with the economy. It had everything to do with ultra-low interest rates and the Federal Reserve's money printing, to the tune of $85 billion a month (that's something like $30,000+ per second!).
But nonetheless, there's an uptrend in the stock market, contrary to the flat economics that we have right now. (The gross domestic product growth in our economy has been flat for three quarters now, around a measly 1.7-1.8 percent of growth. In a healthy economy, we'd be growing at 2.5 to 3 percent growth).
So if the money printing stops, or materially lessens ... look out below!
But from a technical/charting perspective, there are some serious warning signs I'm seeing that will at least bring about a serious correction (more so than what we've had thus far).
For starters, back in May, the S&P 500 had a "shooting star" candlestick pattern on its daily chart. This is where a long wick forms at the top of the candle (around the 1,675 level). That's a bearish sign because it shows that investors are jittery and "quick to sell."
Next, in mid-June, the S&P 500 dropped below its 50-day moving average and its moving average convergence/divergence dropped below its zero line. That's the first time that's happened this entire year. And those are both somewhat bearish signs. They show that the uptrend could now be weakening/slowing down.
But the biggest one for me, from a charting perspective, is that the S&P 500 hasn't come anywhere near its 200-day moving average this entire year (and in fact, that even applies to part of last year too).
That's an unhealthy condition and it makes it almost assured to cause a stock market correction. The 200-day moving average is back around the 1,500 level for the S&P 500 and around the 14,000 level for the Dow.
So I told both the Fox Business Network and CNBC viewing audiences this past week that I expected both of those stock market averages to return back to their 200-day moving averages within the next 60 to 90 days (if not far sooner).
From there, we could see stocks bounce back up and go even higher. But just realize that they're going into more dangerous territory all the time, both fundamentally and technically. Ultimately, these levels won't be sustainable.
And if the Fed gets the bright idea to taper quantitative easing anytime soon, this could happen sooner rather than later. But I believe that if they are smart, they'll hold off or they run the risk of undoing everything they've tried to accomplish for the last several years now. Surely they're not that stupid. But time will tell.
Anyway, you can tell my cautious tone now on the financial markets. So, tread carefully out there in the weeks and months ahead. It will likely be "touch and go."
About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of Ultimate Wealth Report. Discover more by Clicking Here Now.
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