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!