Why the stock market will probably make a correction in Q1 2018

Just to recap:

  1. Based on current data, the Medium-Long Term model doesn’t foresee a significant correction or bear market in 2018.
  2. The S&P 500 will be more volatile in 2018 than in 2017, although it’ll probably close higher at year-end. (See the latest study here).

That’s the medium-long term outlook based on my model & discretionary outlook. Now let’s understand the short-medium term outlook.

The S&P 500 will probably make a 6%+ “small correction” in Q1 2018. I think a magnitude of 6-10% is most likely.

We can look at this from 2 perspectives: technicals and fundamentals.

Technical reason for a small correction

Let’s put aside the obvious for now

The current rally is the longest rally in history without a 6%+ “small correction”.

From a pure probability perspective: the longer this rally goes on, the higher the probability of a small correction beginning tomorrow.
Other studies show that the S&P will probably begin a small correction in 1-2 months (i.e. by the end of Q1 2018)!

The S&P hasn’t been more than 5% below its 52 week high in 384 days!

This study is similar to “this rally is the longest rally in history”, with one caveat. It expands the data pool because the S&P will sometimes make a muti-month flat top.
There were 3 historical cases similar to the present. In all of these cases, the S&P went more than 370 days without being more than 5% below the its 52 week high. In other words, these are all extremely long and low volatility uptrends.

  1. May 14, 1965: the S&P began a 10.9% “small correction” the next day.
  2. March 28, 1994: the S&P was in the middle of a 9.7% “small correction”
  3. June 7, 1996: the S&P was in the beginning of an 11% “small correction”.

These 3 historical cases have 2 things in common.

  1. The S&P was either already in a “small correction”, or very close to one. Today, the S&P 500 is making new highs, so a “small correction” has not begun yet.
  2. These “small corrections” were on the big side as opposed to the small side. They were all approximately 10%.

Fundamental reason for a small correction

For starters, there are no long term fundamental problems with the U.S. stock market. U.S. corporate earnings are rising and the U.S. economy is growing nicely. This is why our Medium-Long Term Model doesn’t foresee a bear market.

Here’s the unemployment rate. It’s still going down.

Here’s YoY Industrial Production. Still trending higher.

Here’s New Home Sales. Also trending higher.

Here’s Retail Sales. Flat to trend higher.

You can see that the economic data’s long term trend is strong. There is no reason for a bear market in stocks.
HOWEVER, January’s economic data (to be released in February) will probably make a short term dip.
Economic data released in February tends to fall due to the weather in January. This has been the pattern over the past 7 years, and it’s only getting more extreme thanks to climate change.
This January is extremely cold on the East Coast. Look at these news headlines.

In addition, the economic data right now is about as good as it gets in the short term. It can’t get much better than this. Soon the data will have to make a temporary dip. Here’s Citigroup’s Economic Surprise Index, which aggregates various U.S. economic indicators.

I know a few hedge funds that try to trade the S&P 500 based on short term fluctuations in U.S. economic data. Here’s the conclusion.

There is a weak-moderate positive correlation between the economy and U.S. stock market in the short term. This correlation isn’t very strong, but it exists.

Combining these 2 things

When you combine..

  1. 2 long term technical extremes with…
  2. economic data weakness in February…

The odds of a 6%+ “small correction” beginning in Q1 2018 are very high.

6 comments add yours

  1. Troy, just curious if there are any parabolic moves, rsi divergences, downward momentum price action breaks , trendline breaks/retests that occur before a small correction starts? The last trading day of the year was met with a momentum down move in price but was indeed a bear trap! Which is what I would think caused these 4 days of upside price action combined with the start of the new year fresh money inflows causing such upward price action. Also read a blog by Kenny polcari of cnbc who is a 30+ year NYSE floor guy pointing out how the new market of electronic algos feeds on momentum trade executions which have no bearing on human market sentiment further fueling upside momentum rally’s.

    • Some small corrections have those and some don’t. Not a consistent factor.

  2. Again yesterday algorithm’s took the mkt to new heights – unable to recognize or ‘feel’ the mkt – Understand this one important concept…….computers and automation are STERILE – there is no personality, no energy, no ‘joie di vie’…….Quants and techies have succeeded in ripping the guts right out of the place, they have taken away the very heart and soul of what the capital mkts should be….instead – today we have mindless computers – programmed to just ‘go along’ unable to really ‘make a decision’ the way we used to – when men were men and your word was your bond!

    • I wouldn’t really blame it all in the algos. There have been times in history when the market’s momentum was this strong, and that was the pre-computer era.

  3. So it sounds like sell into January’s current strength prior to new economic data releases in Feb, and then buy the dip on reversal after ~5% mini-correction.

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