Equity indices see the strongest correction since 2016
Higher bond yields is the main culprit
US500 could slide all the way to 2430 points if this is the 5th major correction in this bull market
Traders should track moving averages seeking entry points
A wild rally on equities in January was capped in equally spectacular fashion last week. Following a record setting period without a correction on Wall Street we suddenly have one. The question is - is this the end of the bull market and if not, how deep the correction could be?
Long term view - near the peak
What happened last week was long overdue - we pointed at extremely stretched markets in the weekly analysis 3 weeks ago. If the long term view is taken not much has changed - this 4-5% slide barely changes conclusions. Our long term valuation measure shows equities being close to most overvalued ever, just a notch below the post-war peak from the dot-com bubble. In theory there’s nothing stopping this market to go even higher in terms of overvaluation but the bottom line is that we could be relatively close to the top.
US equities could be extremely overvalued at present.
Are higher bond yields bad for indices?
In a nutshell - yes, they are. Take one of the most basic valuation models for equities - the Gordon Growth Model, and you will see why. In this model a valuation is an outcome of the next dividend, a discount rate being dependent on (here we are) bond yields and a risk premium and a growth rate (of future dividends). All other factors held constant, higher bond yield results in a lower valuation. The trick here is that if an increase in a yield is being compensated either by a lower risk premium or by a higher expected growth rate it may result in unchanged or even higher valuation. However, markets have discounted robust growth and priced risks lowly so now higher bond yields may see little compensation from other sources.
Higher bond yields (hidden under r in the DDM equation above) are bad for stocks unless compensated by higher expected growth or lower risk.
In our view a rise in bond yields alone is not a factor that could see the markets crashing. A pace of this move is what’s intimidated investors but even this should slow down as soon as central bankers hit conciliatory tones. It is what this rise in yields reveals that is dangerous. We have lived in a world of a relatively high growth and cheap money. Many traders have been aware this a part of this mix could be artificial. If the rates move higher for longer we will have a reality check: was the money mis-allocated? is the financial system exposed? will economies manage to keep growing despite the tightening? It’s too early to tell and therefore it could be too early to call the top. If this is just a correction, how deep it could go?
Is this the fifth correction on Wall Street?
You could be surprised to lean that there were only 4 major correction during this 9-year old bull market! They all were quite similar in the percentage range that spanned from 14.2 to 17.2% and averaged 15.5%. That would take the S&P500 (US500 instrument) to 2430 points - quite a move.
The fifth major correction would see US500 down to 2430 points. Source: xStation5
Our sentiment indicator hit the extreme overbought state and reversed sharply. That could be another indicator of a potentially longer correction. In the past levels of 0.5 or slightly lower were attractive for the bulls so given that we are at 1.15 today, further declines cannot be ruled out.
Our sentiment gauge has reversed from extreme overbought level but remains well above the first oversold line.
Watch the trend
Although the long term trend remains bullish, short term one has already changed. When looking at H1 intervals all major indices are below averages. These moving averages worked very well in a bullish trend so traders could consider rejoining a downtrend on retests.
Moving averages can help find entry points.