S&P 500-Correction or Downtrend?

The big question going forward is whether January’s decline in the S&P 500 is a correction or the start of a new trend to the downside.

Short view: It’s a correction that will max-out at 10%, if it even goes that far.

First, there really is no such thing as the “January effect,” which is the idea that January leads the way for the overall year’s performance. There’s no statistical basis to support this and anyway, stocks gained about 34% in 2009 (and about 65% from the March 2009 lows) despite the 9.5% decline in January 2009.

Second, in normal up years, there is an average of three, 5% corrections and one, 10% correction.

Third, and most important, there’s no reason for stocks to be starting a new down trend other than on speculation that the withdrawal of fiscal and monetary stimulus will cause a second wave of economic decline in the second half of 2010.

The scorecard for corporations reporting profits during Q4 is that nearly 80% have beaten the estimates for earnings and that over 50% have beaten the top-line estimates for revenue growth.  Additionally, the first estimate of 4th quarter GDP, widely expected to get an enormous boost from inventory re-stocking, actually did better than expected on several fronts.

In real (inflation adjusted) terms, overall spending slowed to a  2% pace (from 2.8% the previous quarter) after the cash-for-clunkers plan expired but excluding autos, consumer spending increased at a 3% annualized rate, the most in three years. Significantly, the boost in spending ex-autos was supported by incomes rising at a 4% pace, the most since Q2 2008, and from the 2.2% growth in wages and salaries, the best performance in two years.

Allow me to go back to the idea that investors will discount future value based on the withdrawal of fiscal and monetary stimulus. The Obama administration is now focused on jobs (as well they should have been since day 1) and will concentrate their efforts in that direction, For example, they can re-start cash-for clunkers (actually, they can start cash-for-anything programs) and can always extend the tax credit for homebuyers. Second, the Federal Reserve will absolutely jump back in to support growth if necessary, which is what they’ve repeatedly promised to do in their recent statements.

In my opinion, stocks could be somewhat more than half-way through a correction that is likely to max-out at about 10%. Let me explain.

I’m using a Fibonacci sequence to measure the retracement of the decline in the S&P from the time that Lehman Bros. collapsed in Sept 2008 to the March 2009 lows. The last high was made nearly exactly at the 80.9 level, meaning that 80.9% of the collapse after Lehman Bros. had been made back before the latest correction began.

Now, here’s the best part:

A 10% correction from the 80.9 fib level would put the S&P at about 1036, nearly exactly at the 61.8 retrace level, which is where the market last found a major level of support back in November!

I will say this however:

Stocks could just very well turn around from here, especially if the numerous Purchasing Manager Indexes from all over the world (including China) turn out better than expected next week (as I believe they will).  And all of that will be further supported if the NFP, scheduled for release next Friday, turns out better than expected (which is hard to estimate in advance).

On the other hand, we’re seeing stocks decline even though many economic and corporate earnings reports have beaten expectations, so it wouldn’t be surprising to see price move towards that 61.8 retracement level. But unless these reports turn out to be very disappointing, which I do not expect to see happen, the present correction is likely to max-out at 10%.

Matt “NewstraderFX” Carniol
fxinstructor.com