(09/02/14) Correction? Signs to Watch

I believe that a correction (greater than 10% loss) will come in due time. However, due to excessive bearish calls at this time, an equity sell-off is not likely to happen during the next few months, explains Joon Choi in Systems & Forecasts.

The S&P 500 Index (SPX) seems like it’s nearing a critical point in terms of market cycles. It peaked out in August of 2000 and October of 2007—an 86-month span.

Assuming that the stock market will peak out 86 months from the 2007 highs, the top should be at end of the year. Prices may challenge the 2,000 level again but should not break above the level.

Meanwhile, the 10-year Treasury yield also points to an equity top. It is making lower highs (equivalent of higher highs on Treasury bond prices since yields are the inverse of prices) as the S&P 500 Index is making higher highs.

In other words, both the equities and bonds are rallying together. The significance of a divergence between the yields and stock prices is that the previous three corrections of 2000, 2008, and 2011 were preceded by the same formation.

So, is the stock market setting up for a correction? I believe there are a few signs to look out for as a big sell-off starts.

The small cap Russell 2000 Index (IWM) tends to lead the large cap S&P 500 Index SPX. IWM is down 1% for the year but SPX is up 6.5% as of August 13. This underperformance has the bears pointing to an imminent stock market correction.

IWM seems like it may be completing a head and shoulder pattern, which tends to form at market tops. This pattern developed in 2008 and 2011 in the beginning stages of large equity selloffs.

In addition, you should pay attention to the S&P Regional Bank Index (KRE) because I believe this index is a good gauge of the US economy’s health. Similar to IWM, KRE has almost completed a head & shoulder formation.

It seems like the question is not if, but when will the big market sell-off take place. In addition, the head & shoulder pattern is almost complete for IWM and KRE. However, if IWM holds $107 and KRE holds $36.50, the pattern will be negated. If the two ETFs do not hold the levels above, I strongly advise reducing equity exposure because the correction is under way.

Too many people are calling for weakness in stocks during the August to October period; historically the three weakest months. Big market sell-offs simply do not occur when many investors are expecting it to happen.

Instead, I believe a correction will occur during the favorable seasonality period (November to April). Further, seasonality investing in a presidential mid-term election year (which happens to be this year) is historically the most profitable period for equities and few will be expecting a correction.