Exceedingly overextended prices are a recipe for disaster, and now several indicators are showing readings in dangerous areas. Last week (week of January 14) saw another small weekly gain (0.90%) – and we believe conditions are now ripe for a sharp correction downward. All the classic characteristics of a correction set-up are present.

In this article, we will examine several well-established indicators that are signaling that prices have moved too far, too fast. We will discuss why we believe prices have climbed too high, consider when we expect stocks to enter a correction, and provide you with some downside targets for where the correction will bottom. To conclude, we'll give you specific instructions for how you should prepare for this potentially loss-inducing market event.

Please don't jump ahead – you should understand the critical elements before you read the conclusion!

While underlying market conditions are exceptionally robust, with first-quarter earnings estimates being dramatically hiked across the board, stocks have been accelerating sharply higher without a pause. It has been five months (mid-August 2017) since the S&P 500 last visited its 20-week moving average, which we consider to be the intermediate-term (3-6 month) trendline for stocks.

Since that time, the SPDR S&P 500 ETF (SPY) has accumulated 16.52% without rising more than 2% in any single week. Furthermore, the worst weekly loss in 2017 was an astoundingly benign -1.4% in early August. The rally since November 2016 has been smooth, steady, and consistent with little or no repercussions (so far) for investors taking too much risk. That situation is going to change soon, however.

While that might sound like the recipe for a "perfect" stock market rally, the S&P 500 and other market indices – especially technology-related indices – are becoming extremely overextended without anyone really noticing. Note that we are not addressing overvaluation in this article. The overextension we are talking about refers to an investment asset's price relative to its long-term price pattern.

After a long, steady climb in the 'perfect rally' – one that has proceeded steadily higher without a setback of note since November of 2016, the S&P 500 has now reached a level that is extended 11.3% above its long-term, 40-week EMA. This is far too high for our taste, with the maximum that stocks usually ever get above this long-term average at about 12% to 13%.

Chart 1 below shows the identification of these conditions in an SPDR S&P 500 ETF (SPY) chart for the last nine months.  In addition to the 20-week and 40-week moving averages, this chart is highlighted by gray-shaded Bollinger Bands, which are volatility bands that stretch two Standard Deviations (SD) above and below a 20-week centerline. Bollinger Bands will expand when volatility increases and shrink when volatility declines. 

When used with a weekly chart (which we use exclusively), the Bollinger Bands should contain about 97% of all weekly stock price candlesticks. If a weekly candlestick closes above the upper Bollinger Band or below the lower Bollinger Band, It is a high-probability indication that a reversal is imminent, which is why this chart causes us concern...

Chart 1:  The S&P 500 is very overextended. After a long, steady climb since November 2016, the S&P 500 has stretched 11.3% above its long-term, 40-week EMA. This is especially protracted, with the highest that the S&P 500 has ever been above its long-term trend line at about 12%-13%.

Many of our quantitative investment strategies use Bollinger Bands as part of their signaling system to identify times when market conditions have stretched too far, too fast (either higher or lower), thereby identifying ETFs that are ripe for a reversal (either lower or higher). In the top right of the chart, you can see that in each week of the last three weeks, the S&P 500 has challenged the upper edge of the upper Bollinger Band.

Three weeks ago, i.e., the first week of the New Year, the S&P 500 ETF closed precisely on that steadily-rising upper edge of the gray-shaded Bollinger Band. Then last week (week ending January12), SPY closed 0.65% above the Bollinger Bands. This was a 'yellow - flag' warning that conditions were getting too extended. This week  watched as SPY open the week above the upper Bollinger Band and then closed the week nearly 1% more above that level – creating a situation in which the entire candlestick for the week opened and closed above the top edge of the Bollinger Band.

We consider this condition to be a 'Red-Level: Short-term Pullback' warning.

We can virtually guarantee that something will occur very soon to bring stock prices back into alignment with their long-term averages. It would be stunning if that 'something' doesn't occur in the coming week or two. It could be a slow, sedate decline that steadily brings stocks back to their intermediate-term or long-term trendlines. However, in these type of situations – i.e., a strong bull market with an additional catalyst to the upside (December's corporate tax cuts) that causes stocks to accelerate higher at an even faster pace – with multiple extreme, dangerous Indicator levels, usually results in a correction that is fast and violent.

Those intermediate and long-term technical levels are the 'base' from which stocks are regularly launching-from or return-back-to as investor sentiment ebbs and flows. In 1930's Graham-and-Dodd value-investing terms, they are the 'Mean' to which prices are always returning.

In a bull market, stock prices will stay well above their long-term, 40-week or 50-week moving average (which one depends on the index in question), and most of the time prices are above their intermediate-term, 20-week moving average. However, stock prices will regularly return back to those averages and use them as a base, bouncing off of the averages and then surging higher again with better valuations and renewed investor interest from those who were looking to 'buy on the dip.'

Whenever stock prices climb too for above these long-term moving averages, you can rest assured that they are soon going to reverse course and 'fall back to earth,' so to speak. With the S&P 500 currently more than 11% above its long-term, 40-week EMA, you should expect stocks to head the other direction soon, and it is highly likely they will return to either their 20-week or 40/50-week EMA – either immediately or spread out over a matter of weeks, and possibly even months.

However, at levels such as today's, it's likely there will be a sharp snap-back downturn that takes the index back to its 20-week moving average, then there could be weeks of turbulence before finally reaches its long-term, 40-week moving average.

Based upon current readings, we expect a correction event to unfold very soon
– perhaps in the next 2-3 weeks at the most.

RELATIVE STRENGTH AT ITS HIGHEST LEVEL IN NEARLY 90 YEARS

One other measure that is signaling that stock prices are at an extreme level that cannot last is the well-established Relative Strength Index (RSI). When we recently ran a weekly chart (we do not use daily charts because of the counterproductive noise), spanning from the S&P 500's creation in 1925 to present, we noticed that it currently has an RSI level that is the highest in nearly 90 years – since the hearty bull market that led to the infamous 1929-1932 market crash!

Chart 2 below shows identification of the current level at 88.39 on the far lower right, the prior two times when it got within shouting distance – at 86.30 in 1959 and 85.85 and 1943 – and the multiple readings that occurred in the late 1920s that were higher than today's reading. However, that's not a record we hope we see repeated anytime soon, considering the disaster that it led to for the world, including the Great Depression and World War II, for starters.

Chart 2: On a weekly chart, Relative Strength (RSI) is at the highest level it's recorded since the Great Depression. That's not a status that bodes well for stocks.

This extremely elevated RSI is just one more reason we believe that stock prices are going to pull back sharply in the near term.

You're probably wondering, "If stock prices do reverse course soon, how far can we expect them to fall?" That's precisely what we will answer in the next section…

CORRECTION TARGETS

Chart 3 below lays out two possible scenarios should a correction unfold in the coming weeks. As mention earlier, the intermediate-term trend line is a very critical level, one which we consider to hold sway at the 20-week moving average, generally speaking. Other analysts may assign different intermediate levels for stocks, but our research has confirmed that the 20-week moving average (not the EMA) is the highest-probability intermediate level that investors (in the collective) use as a critical level. It is also a level that will most assuredly be reached when the correction begins (which is the consensus of the ETFOptimize analysts).

MARKET SCENARIO 1

The first scenario is shown in red and addresses the situation of a correction that begins sooner – perhaps early this week – which is the more conservative possibility to consider. The scenario we have laid out in red in Chart 3 below shows a likely near-term pullback target, should stocks reverse course and turn downward early next week – before they are able to become even more overextended. The more protracted and stretched conditions become, the more energy a reversal will carry when it reverses course.

This is classic Newtonian physics, which seems to apply to stock prices as equally as it pertains to the planets. However, perhaps someone should've told Mr. Newton that the properties of motion he discovered and published in 1687 were also applicable to investments before he lost nearly everything in one of the early stock market crashes (1720).   Newton lost more than $3 million in today's dollars when the South Sea Company stock imploded. Consider today's article as a warning of something dangerous, but unlikely

A correction that begins sooner may perhaps only fall to the 20-week moving average, which would probably happen in just a week. This rapid selloff would entail an approximate -6% to -7% loss for buy-and-hold investors using the SPDR S&P 500 ETF (SPY). If you hold a different ETF, you can look up the distance of the 20-week moving average below your position's current price to calculate this amount for yourself.

Chart 3: Shown above are two possible future scenarios for correction-related losses should a pullback develop in the coming weeks.

MARKET SCENARIO 2

The second scenario is shown in green in Chart 3 above and would entail a correction that begins in the next 2 to 4 weeks. Considering the strength of this last leg of the current rally, this would likely mean that stocks will continue higher from here – perhaps significantly so. Such a development would mean the parabolic pattern that is developing now would extend even further, possibly accelerating higher at an even faster pace, and for most investors, it will likely get quite dangerous if they attempt to participate by timing their trades.

When these 'blow-off tops' develop, all the reasonable ways that investors have historically determined when to enter and when to exit the market falls by the wayside as stocks become a feeding trough for a frenzied pool of greed-driven human and machine piranhas. Most individual investors, should they decide to participate in this madness, are likely to lose their shirts.

High-frequency trading programs can calculate and respond thousands of times faster than you or me. They will eat any homo-sapien participants alive three times over, all while the first neurons of the human brain are only beginning to fire with the embryonic stages of ideation that it might be a good idea to click the 'Sell' button and get the hell out of there.

You know yourself better than anyone else, but if you are going to try to time your entry and exit – without the benefit of an ETFOptimize quantitative Premium Strategy – to trade around or through the coming correction, you may want to do like we used to do 20 or more years ago (before quantitative strategies) – "get out while the getting is good," as they say, before there is a rush to the exits. Subscribers to our rules-based models know that several have already taken the precautionary step of moving to defensive ETF positions or cash-proxy ETFs (depending on the strategy).

Of course, you may not believe the prospect of a correction is as significant as the picture we have painted here. But – as they say, "it's your funeral."

 

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