Opinion: Get ready for a 5%-10% stock-market drop
Published: Aug 30, 2016 10:14 a.m. ET
Why the market may fall 5%-10%, and what you should do to prepare
Getty Images Hold on: It could get a little rough for stock investors over the next two months or so.
If you have trades on that you've been thinking about selling, it's time to sell. If you have a lot of margin on, bring it down. If you have little buying power, find a way to raise some.
The reason: There's likely going to be a significant selloff over the next two months.
Of course, making short-term market prognostications isn't easy. Some say it's even a fool's errand.
It might be. But sometimes, the signals align to tilt the odds in favor of a market move. That's where we are now. I'm not predicting the start of a bear market. I think the U.S. and global economies will hold up. So I wouldn't sell medium-term stock positions — meaning stocks you plan on holding for a few years.
But near term, meaning over the next two months or so, it could get a little rough for stock investors. How bad?
"I think a 5% or 10% correction is likely," says Robert W. Baird chief investment strategist Bruce Bittles, who turned more cautious on the markets over the past few weeks.
Here are seven reasons the market looks vulnerable, and what you should do about it.
1. Investors seem too bullish again
Sadly, the crowd is often wrong in the market. And right now, the crowd is quite bullish. "Part of the problem here is a lot of optimism has come into the market in the past three weeks, and now we consider it pretty extreme," says Bittles.
There are many ways to measure investor sentiment. Here are a few data points that show investors have turned pretty bullish.
- Investors Intelligence, which tracks Wall Street stock-letter writers, shows the share of bulls has risen to 57%. That's the highest reading since May 2015, and moves above 55% often suggest a near-term peak in stocks is at hand. Meanwhile, bears are at just 20%. The spread between bulls and bears is the widest since February 2015.
- Surveys by the National Association of Active Investment Managers put exposure to stocks at 98%-99%. No investment managers reported a net short position in stocks. Bears have thrown in the towel.
- The CBOE Volatility Index (VIX), the so-called "fear index," has been in the 11-13 range for most of August, signaling investor complacency. Generally, anything below 14 can be a bearish signal for stocks, because it signals too much complacency among investors.
- Demand for put options (a bearish bet) is down relative to demand for calls (a bullish bet).
2. The media are turning bullish
Like investors, market commentators in the press often turn confident and bullish before bouts of weakness. So it's a bit troubling for longs that a recent New York Times "strategy" article made the case that stocks can move higher from here because Fed Chairwoman Janet Yellen is signaling interest-rate increases may be tame, and corporate earnings are going up again.
Both may be true. But where are the media commentators who were (wrongly) in full-fledge panic mode about Brexit a few weeks ago? Or about the outlook for stocks and the economy in January and February? Doubters are a lot more scarce in the media now. A recent Bloomberg article went as far as to say the currency traders "can't lose." Yikes. As a long, I'd prefer have a nice wall of worry in place for my stocks to climb. It will come back. But to get it back, we may need a good 5%-10% correction.
3. We are entering a seasonally weak period for stocks
Maybe it's because the weather turns cooler, putting people into harvest and storage mode — for stock market profits, as well. Maybe it's because of heavy mutual-fund tax-loss selling ahead of the Oct. 31 close of the tax year for most funds. (This is a separate issue from when they formally distribute those gains and losses to shareholders.)
For whatever reason, September and October can be trouble for stocks. September is the weakest month, and early to mid-October often brings the low point for the year. In short, the season of market ghosts and goblins is upon us, and they might spook investors yet once again.
Read Mark Hulbert: September is the worst month for U.S. stocks, and no one knows why
4. Elections can be harsh on stocks
September-October can be particularly rough on investors during presidential election years as voting day nears and debates heat up, point out Bittles. Post election, markets can tumble when the party in power changes. That's because markets prefer the status quo.
Donald Trump, the Republican candidate, may or may not turn out to be a good president, should most polls be wrong and he wins. Who really knows? But regardless of how that would ultimately work out, his election could shake up the stock market near term because of investor preference for the status quo.
Read: The stock market has already picked the next U.S. president
5. Insiders are too cautious
The ratio of insider selling to buying has risen to worrying levels. This ratio over the past eight weeks now stands at around 4, as tracked by Vickers Weekly Insider. Generally, anything over 2.5 signals caution for stocks. Here's another red flag from the insiders: The rate at which they are filing Form 144s with the Securities and Exchange Commission (which register restricted shares to enable selling) is at a level not seen since March 2015. "We remain on alert," says David Coleman, of Vickers Weekly Insider.
6. The market is losing momentum, and stocks look overbought
Technical analysis is more art than science and isn't foolproof. But it often works, and it's useful as a piece of any mosaic you build to form a market call. Right now several technical signals suggest the stock market is running out of steam.
On the simplest level, the S&P 500 SPX, -0.15% has been stuck in a trading range for about a month. Next, during this time, the list of stocks setting new highs has been narrowing. This suggests a loss of momentum, says William Delwiche, an investment strategist at Robert W. Baird. Recent market highs "have not been confirmed by a higher high in momentum," he says. This tells us the recent rally is missing important underlying support.
And the TRIN, a volume-weighted advance-decline gauge that basically measures the "oomph" behind market moves, has been weak. The NYSE TRIN was recently at .55. Anything around .5 or below can be considered bearish for stocks.
7. Interest-rate fears could return
In her speech at Jackson Hole last week, Yellen made it clear that interest-rate hikes are definitely on the table for this year. "Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal-funds rate has strengthened in recent months," she said.
I doubt the Fed would risk shaking up the markets just ahead of an election by raising rates at its Sept. 20-21 or Nov. 1-2 meetings. But anything it possible.
Even without a rate hike at those meetings, investors could get spooked enough about one to cause market damage. Yellen, for example, also made it clear in her speech that the Fed is as "data dependent" as ever. Thus a round of strong numbers on employment or inflation could put investors into a panic about a rate hike even before the elections -— whether it actually happens or not.
Read: Here's where every Fed official stands on interest rates after Jackson Hole
The bottom line
The good news is that market breadth, overall, remains pretty positive, says Bittles, suggesting any selloff will be contained.
And the U.S. and global economies seem unlikely to go into recession soon. So selling medium-term stock holdings seems unwarranted. I'd exit questionable trading positions here and look for other ways to raise cash.
It might also make sense to buy some ProShares VIX Short-Term Futures ETF VIXY, -0.80% as insurance, or VelocityShares Daily 2x VIX Short Term ETN TVIX, -1.69% The second one is for the bold, since theoretically it moves twice as much.
These instruments go up when market selloffs occur, fear increases, and the VIX VIX, -0.08% rises. So owning them can cushion your stock portfolio. Just remember that the way these instruments are constructed — through futures positions that have to be continually rolled over — they naturally decline in value over time. So, unlike stocks, they aren't buy-and-hold instruments.
Neither the TSP Strategy group, nor individual members, are licensed or authorized to provide investment advice. Any statements made herein merely reflect the personal opinions of the individual group member. Please make your own investment decisions based upon your personal circumstances.
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