Are Stocks Really Ready For a Correction?

Are Stocks Really Ready For a Correction?

July 26, 2023

Print/Read as PDF

We are in the final week of July. In the final week, not a lot of economic reports to be particularly concerned about, but a very important Fed meeting just after you get this report (Wednesday, July 26th at approx. 11:00 EST). The other thing that is important this week is that we are now in the thick of earnings season and more specifically the earnings are flowing from the "Magnificent Seven" big-cap technology companies. Last week the markets sort of wobbled after a very nice upside the first week of July. Along with this wobble, the boo birds came out and are pounding their drum about the "necessary" pullback in the markets. Since the markets are benefiting from earnings that are better than feared and a Fed that has clearly changed course from trying to squash inflation and the economy in the process to feeling that they have done a pretty good job in their intentions the stage appears to be set for additional upside. While many are coming out and stating that the market is in desperate need of a correction and that it has gone up way too much, the reality, as I see it, is that maybe it could digest a little bit but with so much cash on the sidelines in money markets, short-term CDs, and short-term US Treasuries, the fear of missing the next move higher could draw large amounts into the markets and keep it from really correcting all that much. See the chart of cash on sidelines below. Along with the cash on the sidelines, I have also included a graph that shows how much money, so far this year has been put into money markets, bonds, and US stocks. I pose the question, if money has really been removed from US stock mutual funds on a net basis since the beginning of the year, are stocks really ready for a correction?

Please take one more moment and marinate on the graph above. This is really quite perplexing. Given that short-term interest rates are really attractive, it is no wonder so much money has been put in money markets and bonds, but if the equity market is really as strong as it is, imagine what would be the case if money had actually been put into rather than taken out of equity mutual funds and ETFs!

Another small point that was brought up over the last couple of weeks was that the most visible index this year, the NASDAQ 100, better known as the "QQQ," was rebalanced Monday and some of the voting power of the top five positions was removed. This is because they have risen to a point where it was believed that their collective vote in the movement of the index was too great and that by rebalancing and lessening their vote that the index might better reflect the action of the market it wants to represent. Below is the link to a short YouTube video that explains what exactly was done for those that would like a more complete explanation:

https://www.youtube.com/watch?v=vSWfh2Ewte8&ab_channel=BloombergTelevision´╗┐

In this week's note, given that the market has rallied very nicely and that many prognosticators are looking for a correction of some level, I felt that it might be valuable to bullet point the pluses and minuses that exist and then close with what I am expecting. In looking at the trendlines the markets have not provided many indications of internal breakdowns that often precede pullbacks of consequence. 

Specifically, the following are problematic and normally signal a pullback is near: 

  1. Breadth and momentum divergence on hourly and daily charts. This is when a fewer and fewer number of companies are going up in price in the shorter-term (hourly and daily). In actuality, the number of companies joining the party has actually grown and the number sectors that have been resting during the advance are waking up. 
  2. DeMark exhaustion on multiple timeframes and on multiple benchmark indices. Tom DeMark is a very highly respected market technician and he focuses on exhaustion points- both up and down. Currently, DeMark's work says that things have been going up for a long enough period that maybe it's time to rest a bit.
  3. Exiting a bullish seasonal time and entering a bearish one (Both Aug. and Sept.). In looking at seasonal time periods, August and September tend to be particularly difficult. 
  4. “Short-term” individual investor sentiment gauges have entered extreme bullish territory. Many measures of positive or frothy investing by individuals normally get a bit tired after this much of an advance. 
  5. Cycles show weakness in August. Much like the seasonal soft periods in August and September as well as DeMark's indicators seen above, Elliot Wave types of cycles point to August not being strong to the upside. 
  6. Defensive trading looks to be coming back with a vengeance just this last week. The Consumer Staples and Utilities sectors that have been invisible since March have come back to life. 
  7. Resistance has been reached on NYSE Composite and Equal-weighted S&P 500. When indexes go up to previous high points, sometimes these high points are sort of like brick walls, and investors that didn't sell the last time that the market was at that point now have a logical place to exit on their second chance to do so at the current levels. 

To the Bull’s credit, however, a lot remains right with this market, and these are as follows:

  1. Weekly uptrends (considered stickier and longer-term) remain intact, and while QQQ is overbought, other equal-weighted indices are not really that overbought, i.e., Equal-weighted S&P 500, or Value Line’s Arithmetic index show still quite low relative strength readings.
  2. Rally has broadened out substantially in the last couple of months, exactly the opposite of what typically happens before a correction starts. When markets get tired or are going to suffer fairly substantial declines, there tends to be fewer and fewer companies going up and joining the party. At present the opposite is happening- more companies are rising than just a few big-caps (Magnificent Seven) that led the advance off the lows.

Usually, when the Advance/Decline line hits new all-time highs the indexes follow suit. This is totally contrary to what most analysts are expecting currently. Also, as shown above, tons of cash on the sidelines. Up $1 Trillion just since last October! So an August correction isn’t for sure due to the majority of people still being underinvested.

     3. DJIA and DJ Transportation Average have broken out to 15-month highs. This is known as a "Dow Theory Confirmation." This is when the different Dow Jones Indexes confirm the leading index. In this case, the Transports are now confirming the Industrials.  This is a very "old school" confirmation signal. 

     4. None of the heaviest constituent sectors within SPX, namely Technology or Financials, have broken their respective relative uptrends vs. S&P 500.  Healthcare, Oils, Staples, and Utilities have actually strengthened.

     5. Key market Technology leaders have just pushed back to new all-time highs this past week.

     6. Institutional sentiment has NOT gotten as bullish. Current readings are still showing institutional investors are particularly apprehensive and only have approximately 17% invested. Also, despite CFTC data showing some short covering, this remains largely neutral, not bullish.

    7. No evidence of weekly negative momentum divergence and this remains a very important piece of the puzzle as a positive.  To expect a large correction after a 10% rally just since mid-March in SPX,      markets will need to start to wither more than they have should there really be a correction materializing. The markets are actually going from a "no bid market" (when nobody wants to buy anything,) to a      "no entry market" when nobody really wants to sell anything. 

The one last point that I would like to make is that of the current debt level of the US Government and how destructive this is to the whole fiber of our financial system. I bring this up because it becomes more and more difficult for the Fed to raise interest rates, when doing so not only makes the pure cost of servicing the debt go up, but the cost to service the debt go up at a time that the economy is softening, and the tax receipts are dropping at the same time. This is not a good combination. I am including below two graphs. The first one is Federal tax receipts. As can be seen at the far right, they are plunging due to economic softness. The second one is a measure of the overall interest payment in whole dollars as compared to the current annual defense spending. Again, a very graphic depiction of how the amount of interest being paid is rising at a dangerous rate.

The last point that I will finish with is the quote from Goldman Sachs from July 20th, where they state that they expect this week's hike to be the last of the cycle. I think there needs to be more economic proof that this is the case, but I think it is worth noting that Goldman is choosing to make this statement publicly. 

-

-

Get Ken's Weekly Market Commentary Delivered In Your Inbox!

Click Here to Subscribe´╗┐

-

-

-

-

Important Disclosures: 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy. 

Investing involves risks including possible loss of principal.

The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.