I like to use analogies when I explain stock market probabilities. For example, in my last blog, I noted how overbought the market was. I noted that the indicators suggesting that the market is overbought don’t provide super timely immediate sell signals. They simply present the fact (not the opinion) that markets are higher risk for a correction (not crash!!!) than normal. My analogy is that of running across a quiet road vs. running across a busy highway. Both situations carry the risk of being hit by a car. Clearly, the highway run is more risky. And that’s where we stand now. We’ve been running across the market highway for a couple of weeks. That does not imply we won’t make it to the other side. It’s just riskier.
Ok, so here’s my next analogy. I wrote about this analogy in my book, Sideways. I liken the market to be like a balloon. When the market is low, it’s like a deflated balloon. As the market rises, the balloon is being inflated. All is good for the party. But when the market gets “too high”, it’s like an overinflated balloon. The balloon is living on borrowed time. One day, a person walking by brushes the balloon with their belt buckle. Boom goes the balloon. Everyone blames the guy/gal and their darned belt buckle. In reality, it was the balloon that was overinflated. It was looking for a reason to pop. Any number of things that wouldn’t have punctured a normally inflated balloon’s skin would pop it when it’s over-inflated.
The coronavirus flu is the belt buckle to the over inflated balloon. The news media has convinced market participants that the stock market has begun a decline because of an outbreak of a virus in China. True, the virus is the trigger. But its not the cause of this correction. Overbought sentiment, overbought momentum, high PE ratios are the cause. The market was looking for an excuse to retrace. Does that make sense to you? I hope it does. I hope that you too can see through this noise, and look at the big picture.
Here’s a graph by Charles Schwab on the market and various epidemic scares since 1970. Notice how, beyond the immediate reactions (1 month returns) of the market, things seemed to normalize thereafter.
How low can we go?
Perhaps you will recall your grade 12 math class on statistics. A sequence of numbers that are trending will have outliers to the upper and lower band. When the numbers go too high or low within that trend, the tend tends to regress towards the average. This is called regression to the mean. That’s what the stock market is doing right now. The balloon needed to deflate. It was going to be the impeachment trials, or the trade deals, or the Iran situation, a messy Brexit deal, or a virus, or a bomb going off somewhere. The market needed to correct. How low can it go? Well, you will note that markets tend to channel bullishly after consolidations (the boxes noted in the chart above). The lower end of the current channel might project somewhere near 3100. Or, the market might find a home in the middle of the channel near 3200, which is not far off of where it stands today. Note how the market hung-out in the middle of its last trend channel much of the time between 2016 and 2018. It tested the lower channel a couple of times in 2016, and ran along the lower channel in mid-2018.
So I’ll stick my neck out and suggest that a buying point will land between 3100 – 3200 on the SPX. Let’s see what happens.