This is What Could Finally Pull the Rug Out from Under the Market

The Dow and S&P 500 notched new highs this morning. So what else is new? Stocks have been going through the roof pretty much all year with no let-up in the upside momentum, save for a few minor pullbacks of 3% or so.

I’ve been warning for some time now that this overbought, overvalued market is also way overdue for a correction. And I’ve been proven dead wrong so far. But the fact is, the longer it takes for a typical pullback to materialize, the more severe it is likely to be.

At the risk of sounding like a broken record, here are several bearish red flags to watch closely. That’s because any one – or some combination – of them could quickly pull the rug out from under the market …

Red Flag #1 – Bad breadth: Granted, stocks are hitting new highs almost daily. But I notice a glaring lack of conviction in terms of market breadth – fewer advancing vs. declining stocks, which you can see in the chart below – and fewer new highs.

Plus, trading volume has diminished steadily in recent weeks at a time of year when it typically picks up.

These are classic signs of a market about to run out of gas. And they tell me the long-awaited correction is finally looming.

Don’t get me wrong; I’m not expecting a repeat of the 1987 stock market crash, which took the Dow down 22% in a single day 30 years ago last week. But we’re way overdue for a typical 10% correction.

And there’s a long way for stocks to fall, because they’re so overextended to the upside right now …

Red Flag #2 – Stocks overextended: In addition to cycles analysis, I keep a watchful eye on several tried-and-true technical indicators of price action for the markets.

One of the best is relative strength – which is a popular measure of momentum.

Specifically, the Relative Strength Index is an oscillator that moves between 0 and 100 and reflects the strength of a market’s trend. When RSI turns up from a very low level, it signals an oversold market, which may be a good buying opportunity.

But as you can see clearly in the chart below, the S&P 500 is at the other extreme …

A very high RSI reading – 70 or above – signals an overbought market that’s ripe for a correction. And sure enough, the RSI for the S&P 500 has been above 70 for 15 straight days. That’s a rare occurrence that typically signals a correction of 5% or more.

All the market needs is a catalyst to break this complacency, and there are plenty of potential candidates …

Red Flag #3 – Rising headline risks: North Korea is the most obvious flash point right now, but by no means is it the only one. Just take a look at some recent headlines …

North Korea has upped its war talk once again, warning the United States it faces an ‘unimaginable strike at an unimaginable time.‘ ”

Or how about the Middle East, where Iraq’s offensive against the Kurds threatens oil supplies? Then there are ongoing conflicts in Syria, Yemen, Libya, Turkey and the Ukraine … just to name a few. A flare-up in any one of these hot spots would quickly shatter the stock market’s complacency.

Or how about Europe?

Stocks Drop as Spain Crisis Heats Up.

Millions of Catalans protested for self-rule over the weekend, they want out of Spain. And Spain responded by seizing control of the autonomous region, actions that likely foreshadow large-scale civil unrest and probably martial law in one of Europe’s most-populous nations.

And while we’re on Europe, do you remember this headline from early 2017 …

EU banks crumbling under 1 trillion-euro severe debt as toxic loans threaten CRISIS.

This story broke back in January. And it wasn’t some prophet of doom-and-gloom saying it either. It was the chairman of the European Banking Authority sounding the alarm, the EU’s top banking regulator!

He warned flat-out that the amount of toxic debt held by EU banks has reached “urgent and actionable” levels. And guess what the EU has done about it? Absolutely nothing!

Just because the EU has been relatively quiet lately, don’t be fooled into thinking their banking and debt crisis is over … not by a long shot.

Bottom line: There is no shortage of potential risks to the market that investors are largely ignoring today. But complacency almost always gives way to a spike in volatility. That, you can bet on.

At this point, the consensus expects clear sailing for stocks through year-end. After all, this is seasonally the strongest time for stocks. But I believe the consensus may have it all wrong this time.

Investors are fooling themselves if they believe the stock market will continue to “melt-up” forever. Any one out of dozens of potential catalysts could trigger a sharp correction in this overbought market.

Forewarned is forearmed!

Good investing,

Mike Burnick

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Comments 11

  1. Richard October 23, 2017

    After all this hype you are telling us this big correction is going to be 10% then on to 31000?
    I was under the impression things were bigger and worse. 10% doesn’t sound as earth shattering as most have forecast.


  2. Jake Sysk October 23, 2017

    1986 Sports Illustrated put a bull on a cover ,Big drop in the Dow 1987 comic strip Family Circus Kid says Dow Jones is a guy in his dad’s office that drinks too much. Market lays an egg. 2017 Watch for this type indicator on the internet, probably a Trump tweet about how great the market is today. Or how his administration keeps the market going up.


  3. Ernie Gulyas October 23, 2017

    Looking at the EU, Hungary in particular, when I was there I became aware that Hungary is very resentful of a bunch of un-elected bureaucrats in Brussels giving orders to countries in the EU. Hungary’s currency the Forint as a result of a weak economy is still the currency used. Many merchants and businesses will now not accept the Euro, only Forints. I would suggest it is because of the terrible state of the big banks. The bottom line is however, that Hungarians also have the undercurrent of separation from the EU. The first step was when they paid of the IMF a year early and tried to kick them out of the country.


  4. Gerald Ringstad October 23, 2017

    I know that you have made the case for mining stocks being on the verge of taking off to the upside in the near future, but if we do have a major correction in the stock market soon, could miners plunge right along with the broad market? Or would minors more likely show relative strength and move up the other way while the rest of the market corrects?


  5. clauschris October 24, 2017

    The Rajoy government is making almost every mistake possible in dealing with the separatist wishes of Catalonia. Clinging to the fact that the Catalan autonomous government is in violation of the SPANISH constitution, when holding an independence vote is as ridiculous, as when the British deemed the American wish for independence unlawful. It was not in the interest of the British. The Spanish constitution was made primarily to keep together the Spanish kingdom and maintain power, so no wonder separatism is unlawful. It is not in the interest of the Spanish.

    Many other regions in Italy, Belgium, the UK, Sweden, (the formerly Danish areas of southern Sweden), as well as many more will be joining the list of separatist movements in the coming years.

    In addition, many countries are less than happy with the EU bureaucrats, who are gaining undemocratic political power. The UK, Denmark and Sweden are representatives of strong economies which were invited, but chose not to join the common currency Euro and similar northern European countries may choose to leave the Euro the next few years. The Eastern European countries wanted to join, but did not qualify, so that is a different story.

    Europe is heading for more political and economic turmoil.


  6. James October 24, 2017

    I think we are in a kondratieff cycle 45 to 60 years, where we have prosperity, recession, depression, and improvements in the economic cycle. We possibly have growth in the solow steady state residual. We also have GDP at factor costs, and GDP at market prices snowballing into a boom. We are currently in a boom, recession, depression, recovery and growth cycle. The Kuznets cycles says that wars are ramping up, however I think we are also in a 40 month kitchin cycle in which fixed short term investments are growing in value. The jugular cycle is an 7 to 12 year cycle. Fortunately we are not in one of those at the moment. I think we are in for a boom. An even bigger boom then the last boom. And then maybe a bust. They should give more teaching hours when they are training economists in universities. Its very hard to have a structure and routine when your only being taught 8 hours a way. Economists are taught to be thrifty and economical. They know how to maximize utility. They also know the marginal rate of substitution between 2 products. We should reward economists more in society with higher wages.


    • Mike October 25, 2017

      Try looking at the “Political Cycles”. The Liberal Progresssive Cycle generally runs 50 years and that is a period of falling Income Inequity and huge gains in the Stock Markets and the associated economic advances. The most recent was 1932-1982 which witnessed the greatest increase in the Middle Class, the Greatest increase in living standards for the average American and the greatest increase in Manufacturing and Economic advances in our history.

      Then comes the Conservative Cycle and Income Inequity goes up and the 97% suffer and the economy begins to faulter. Those cycles generally run about 30 years and result in Stock Market Crashes and Depressions. The most recent was 1982-2008 and ended with the Stock Market Crash of 2007-2009.. 1929-1932 was the Conservative brought Stock Market Crash and Depression before this last one…


  7. Al McNal October 25, 2017

    RSI is not only above 70%. The Dow was at 88.1% RSI 3 days ago. It fell back to 86.41 after Tuesday.


  8. jack October 25, 2017

    So far, in my case, market is going against me. How long do you think my loss will go?


  9. terry shead October 28, 2017

    The deep state want a war in Korea, but it would involve too many other countries, any how that’s not on agenda 21, there are seven countries, Iran is the one they want, but I think Russia and China will have some think to say about that.
    The way to beat these gangsters is screw the oil up maybe water driven cars, that works, they kill people if they get to close, Meyer is one.


  10. OLCAY BALLI October 28, 2017

    Thank you mike