How the next stock market correction will play out


The current “small rally” has lasted 264 trading days. Out of the S&P 500’s 79 historical “small rallies”, only 3 have lasted longer. By the end of October 2017, this will be the longest “small rally” in history. Hence, we think that the S&P will start a 6%+ “small correction” in the next few months. Here’s how we think the small correction will play out.

Volatility will soar, so the S&P will not make a big correction

Our medium-long term model does not see a significant correction on the horizon.
Other measures of stock market volatility (click here and here) also demonstrate that the next correction will be a small one (i.e. around 6-10%).
VIX will soar during the next small correction. VIX’s spike will limit the size of the S&P’s correction.

  1. VIX is extremely low right now.
  2. When VIX is extremely compressed, even a small S&P decline (e.g. 2%) can cause VIX to soar.
  3. VIX is used as a contrarian indicator. VIX spike = S&P bottom. You can appy an RSI momentum indicator ontop of VIX. Historically, when VIX’s RSI reaches 70-80, that’s usually the S&P’s bottom.
  4. So if VIX soars on a small S&P decline, then the S&P’s decline will be limited.

In fact, we have seen this phenomenon in the past few months.

  1. The S&P fell 1.8% on May 17. VIX soared 40% and VIX’s RSI reached 70. That marked the S&P’s bottom and VIX’s top.
  2. The S&P fell 1.5% on June 29. VIX spiked. That marked the S&P’s bottom and VIX’s top.

Here’s VIX.

Here’s the S&P 500.

What will trigger the next “small correction”

We need to wait until Q2 2017 earnings season is over (i.e. wait at least until August). As demonstrated through the S&P’s ascent yesterday, it’s very hard for the S&P to fall on earnings season.
After Q2 earnings season is over, nobody knows what will trigger the next 6%+ small correction.
Historically, most “small corrections” occurred on no news/trigger/fundamental reason. Most small corrections are purely random. However, it’s fun to imagine what can trigger the next small correction.
Seasonality
Seasonality in August is neither positive nor negative, but seasonality in September is bearish. A lot of the stock market’s historical declines occurred in September.
So although seasonality isn’t very useful (it doesn’t always work), the odds of a decline this September are higher.

Debt ceiling
The U.S. will hit its debt ceiling by mid-October, and Congress will have to suspend or raise the debt ceiling by then. So Congress will start to argue about this in September.
Historically, the S&P doesn’t always fall on debt ceiling “worries”. It’s a 50-50 bet (i.e. no predictive value). In fact, the S&P actually went up in 2013 when the U.S. government shutdown!
This is because investors know that the debt “ceiling” debate is a joke (it’s not a real “ceiling” if Congress raises it every time the ceiling is reached). Congress will not let the U.S. default, so this isn’t a real worry. Everyone knows how the story will play out. This is the same political haggling that Republicans and Democrats play every few years to put on a good show about “fiscal responsibility”.
But given that the S&P’s current “small rally” is extremely long, anything can trigger the S&P down. So perhaps the S&P will begin to fall one debt ceiling “worries”. The S&P doesn’t need a real fundamental reason to fall. The real reason is purely technical (i.e. correction is overdue).
Germany’s election is not a risk
Germany will hold on a federal election on September 24. This is no longer a risk to global stock markets.

  1. Poll’s show that Merkel once again has a commanding lead.
  2. The populist movement in Europe is dying. The Netherlands voted against populism. France voted against populism. Theresa May’s Conservative Party did much worse than expected in the UK’s election. Europe is much more left than the U.S. is right on the political spectrum. There are too many cowboys in the U.S. 🙂

Bottom line

Who knows when the next small correction will start. The S&P might very well go up a few percent between now and the next correction. But we don’t think the next correction will be very far away (in terms of time).

  1. For optimal investment returns, be 100% long stocks right now. Follow our medium-long term model and ignore all “small corrections”.
  2. We trade based on our Easy Trading model. We’ll shift from 100% cash to 100% UPRO (3x S&P ETF) on the next 6% correction.
  3. Our portfolio is up 17% year-to-date. If the S&P makes a correction and then makes a new high, UPRO will be up 20%. Our portfolio will be up 40% this year. Not a terrific year, but not bad either.
  4. Our trading strategy guarantees that we will have fat years and lean years. Last year was a fat year – our portfolio was up nearly 100% because we caught the exact January 2016 bottom and rode the entire rally. If the S&P doesn’t make a 6% correction this year, 2017 will be a lean year.

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