The upcoming correction in EVERYTHING

There is a strong correlation between stocks (U.S. and foreign), oil, the U.S. dollar, and gold/silver. These correlations cannot be completely quantified, but they exist right now. These correlations exist because inflation will rise over the next 2 years. Our Medium-Long Term Model predicts that core inflation (excluding oil) will rise, particularly in the 2nd half of 2018. Rising inflation (excluding stagflation) is bullish for stocks, bullish for oil/gold/silver, and bearish for the USD.

  1. There is a clear “risk on” play in global equities right now. U.S. and global stocks are surging like crazy. Momentum is insanely overbought.
  2. Oil and other inflationary commodities are surging as well.
  3. The U.S. dollar is in a bear market because inflation is on the rise (long term). The U.S. dollar always goes down when inflation picks up.
  4. Gold and silver are in long term bull markets. They have an inverse correlation with the USD right now.

As a result of these correlations, the next correction will be a correction in everything.

  1. The U.S. stock market, foreign stock markets, oil, and gold/silver will all make a correction together.
  2. The U.S. dollar will make a bounce within its bear market.

Here’s what I think will happen over the next few months. This is the most likely path. If I had to assign a probability, this case would be 60%.

Step 1: Assets will rally at least 1 more month

1 more month brings us into February.
This study concluded that the S&P 500 will rally at least 1 more before beginning a 6%+ “small correction”. This is logical. The S&P 500 is insanely overbought on every single time frame. When this happens, we typically need to see a bearish divergence on the weekly chart before a correction can begin.

It’s hard for the S&P to make a correction right now in January. The stock market doesn’t always rise on earnings season, but it seldom makes a correction on earnings season (particularly when investor sentiment is already so exuberant).
I expect emerging markets and global stocks to make bearish divergences as well.
Here’s EEM (emerging market ETF) on a monthly bar chart.

Here’s the MSCI All-Country World Equity Index. This looks more like the S&P 500 than EEM because 52% of the MSCI Index are U.S. stocks.

Oil paints a similar picture. Oil’s momentum is insanely high, which means that a bearish divergence to its 50% retracement at $67 is likely. Bearish divergences on weekly charts take at least a few weeks.

Meanwhile, the U.S. dollar has just broken down from multi-year support. I expect the USD Index to continue falling at least 1 month before it makes a bear market bounce.

Gold/silver and the USD have an inverse correlation, Hence, gold and silver will breakout from multi-year consolidation patterns as the USD breaks down. I expect a sizable rally over the next 1+ months.
Here’s silver on a monthly chart. Notice how it’s EXTREMELY compressed by its 50 and 200 monthly moving averages.

Here’s silver on a weekly chart.

Here’s gold on a weekly chart.

Step 2: the correction in everything

No one knows what will trigger the next correction. It could be Trump attempting to pull the U.S. out of NAFTA.
Regardless, I think the S&P 500’s correction will be rapid. I.e. It’ll take 2-4 weeks from top to bottom. Here’s the logic.

  1. Short term speculators and traders are INSANELY long equities right now. There’s no doubt about that.
  2. When speculators and traders are insanely long, their stop losses are very tight. They don’t have enough cash to stick to their long positions when the market goes down. Hence, a normal pullback (e.g. 3%) will trigger a tidal wave of stop losses on the way down. The selling becomes self fulfilling, which is why a 10% “small correction” is more likely than a 6% “small correction”. This tidal wave of stop losses is also why the correction will be rapid.
  3. The S&P’s correction will bring global stocks, oil, and other commodities down.

This is what the correction of September-October 2014 looks like.

Step 3: the correction’s bottom

I’m not sure if the bottom will be V shaped or if the S&P will bounce for 2 weeks at the bottom. This doesn’t really matter to medium-long term investors and traders.

Step 4: blast off

Based on current data, our medium-long term model predicts that the S&P 500’s bull market has 2-3 years left. From a discretionary perspective, I believe 2 years is far more likely than 3 years. The faster the economy and stock market heat up, the less time this bull market and expansion have left.
The upcoming correction will be a “buy the f*#@ing dip” moment. Contrary to popular belief, the stock market doesn’t die on exuberance. When sentiment is insanely high (e.g. right now), the U.S. stock market will not experience a significant correction or bear market in the next year (see study). Equity bull markets end when exuberance has died down a little.
The global economy is on fire right now and will overheat in the next 2 years (see U.S., Europe, and emerging market economies). That’s why we will experience a massive bubble in all assets over the next 2 years. Investor exuberance is based on a simple truth right now: the global economy will heat up in the final inning of this economic expansion.
Hence, this correction will be a once in a lifetime buying opportunity before global assets (stocks and commodities) enter into a full-blown bubble.
I completely agree with Jeremy Grantham’s view: assets will melt-up over the next 1-2 years.

Step 5: the next bear market

It’s too premature to predict how the next bear market will play out. Let’s take things one step at a time. Here are my thoughts.

My one concern

I believe there’s a 60% chance that “the correction in everything” will begin in February (and more likely late-Feb than early-Feb). This is not an extremely high probability like 80% or 90%. Why?
I’m concerned about the U.S. dollar’s breakdown. It just broke down. Normally, a market will continue to fall for a few months after it initially breaks down.
So if the U.S. dollar continues to fall until e.g. March-April, then gold and silver will continue to rally until March-April. Under the current correlation, this means that stocks and oil will not begin corrections until March-April!
Here’s how I would assign probabilities.

  1. A 60% chance that the correction will begin in February (probably late-February).
  2. A 20% chance that the correction will begin in March.
  3. A 20% chance that the correction will begin in April.

My portfolio

Aside from my small Day Trading portfolio, I will remain 100% long UPRO because my Medium-Long Term model doesn’t foresee a significant correction at this point in time. I ignore small corrections. I only sidestep significant corrections and bear markets.

25 comments add yours

  1. Troy,
    Is there any backtesting on how the market will react to the unwinding of the Feds balance sheet during the QE 1.2,3? Fed Purchases? Also is there a way of finding out if the Feds balance sheet contains es futures purchases during the quantitative easing periods by the fed? Was the fed allowed to buy stock index purchases during this time??

    • I don’t think the Fed unwinded its balance sheets after QE1, 2, and 3
      And I don’t think the Fed’s balance sheet contains ES futures.

  2. Hello Troy
    do you remember Shanghai shock in 2007 ?
    it occured during late february and early march
    at that time Nikkei plunged from 18300 to 16500 in only 5 trading days
    if correction will happen in late february
    my target price of SP 500 is 2400-2500 level
    I think it is very appropriate
    kind regards

    • Yes I do remember that. But as I recall, that happened after the SSE Index went up by 2.7x over the past 1.5 years. The SSE is going up slowly but steadily right now.

  3. Troy I did not mean (during) I meant how will the market react to the unwinding of the Feds balance sheet from what they bought to boost up the economy from qe1.2.3

    • That’s the trillion dollar question Matt. Nobody knows because an unwinding of this size has never happened before. Not even close. My guess:
      It’ll be bearish for bonds, but not bearish for stocks. The instant the stock market starts to go down because of QE unwind, the Fed will stop.

  4. Troy,
    This equities correction could be as far as away as July, right? The whole sell in May and walk away.
    Do you think I should start dollar cost averaging?
    Here’s my fear:
    Equities roar, and when the correction happens, it’s higher than the current price right now.

    • Yes it could be as far away as May (I think July is way to extreme a scenario).
      I think I should stop commenting on what others should do with their money (given their position size, cash available on hand, etc). It’s clearly doing nobody any good.
      That’s a really tough question to ask, and honestly it depends on your strategy. Medium-long term or short-medium term? If you can completely ignore the next small correction, then no point in waiting for it. Might as well buy now. But if you care about the next small correction, then you should wait.

      • Hey Troy, I don’t think you should stop commenting on personal situations; it’s doing me, personally, lots of good. Please acknowledge that. Obviously your reply comes with the implicit disclaimers, that part should be common sense. 🙂
        My strategy is more for 2 years, i.e ride this bull market, and somehow leave before the bear of California arrives.
        Thank you for your reply!

        • Well in that case, here’s what I’d do if I were you.
          Go half long now. Then go 100% long when the next correction comes.
          That way if the market keeps rallying, you’re not afraid of missing out because you already have some position. But if the market tops right now, then you can buy the dip.

  5. Troy ,
    S&p futures up a 10th day in a row, shanghei up a 15th day in a row, maybe s&p futures to follow shangheis index with another further 5 days of rallying before some sideways consolidation…. I am losing my sanity with my 2765 short killing my account. The market is now in raging beast mode, hunting and gutting every short out there! Troy, is this beast momentum rally being driven by trillions of dollars of pension funds chasing performance ( trillions of dollars of worldwide pension funds can’t get absorbed into the market on the buy side in 1-2 trading days because of liquidity concerns? Which is why it could take 15 trading days for the market to absorb trillions of fresh money inflows into the market???). Or is it a combination of both shorts getting squeezed and trillions of pension dollar inflows?
    2) perhaps there will be “0” 5-10% chance of a pullback in 2018 and we mirror 2017 with at most a 1-3% very small dip?

    • Matt, 2018 has just started. Trying to guess the reason for every small move is meaningless and impossible.

  6. Instead of hoping he must fear;
    Instead of fearing he must hope.
    He must fear that his loss must
    Develop into a much bigger loss,
    And hope that his profit may
    Become a big profit.
    ~Jesse Livermore

  7. One of the most helpful things that anybody can learn is to give up trying to catch the last eighth-or the first. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.
    -Jesse Livermore

  8. Hi Troy, our work is a treasure trove. Thank you for being so generous. Could you explain your preference for using an ETF over futures contracts?

    • You don’t have to worry about margin calls with ETFs. In addition, ETF’s compound on the way up

      • Hahahahah, good one. Were you even *trading* when August 2015 came, just to cite a recent example?
        Your beloved UPRO went from 70.53 all the way down to 43.00, in a matter of days. Nearly 40% lower in 7 days.
        Don’t think it can happen again? And this time with even worse “compounding” effects, on the way down, when the stupid fund scrambles to liquidate in a vanishing tape? Hilarious.
        Fellas, only proper position sizing and discipline is gonna save your butts.

          • That’s your reply? Citing a model without even explaining what parameters make it? Yea yea, I get it, it’s *secret*. 😉
            Nonetheless, it’s extremely misleading to suggest: stick with a 3x leveraged ETF instead of futures. It’s quite hilarious actually.
            At least with futures you don’t have to deal with and suffer the inevitable (positive or negative) consequences of NAV rebalancing and misquotes.
            As mentioned, only your stops/positions sizes will make you successful. Or not. End of story.

          • And what do you do when you have a margin call with futures?
            I never said stick to a leveraged ETF forever. Only when it’s a big rally within a bull market.

          • Dude, a margin call means YOUR execution was wrong. It’s independent from the trading vehicle you use. Futures can’t be seen as something less preferable to a leveraged ETF. That’s nonsense.
            That said, which was the whole point of my participation in this blog, I won’t delve into the merits of your model or strategy. We all here to try to make money and try not to lose too much. Nothing is 100%.

          • The difference:
            1. With leveraged ETF’s, you can hold until you’re right. You won’t be forced to cut at the bottom.
            2. With futures, you can’t hold until you’re right. You might be forced to cut at the bottom (margin call).
            Yes, it means your execution is wrong. But nobody’s execution is always perfect. ETF’s allow you to wait it out in the case of an imperfect execution. You can’t wait it out with futures.

Leave a Comment