S&P 500: is it time for a correction?

Those who invest in the financial markets worry when the market goes down, but also when it goes up too much. In this last period many are calling for a potential and healthy correction in the stock markets, but apparently Mister Market, as usual, does what he wants. There is no question that a trend must always have a counter-cyclical moment, and everyone is wondering when that might happen and how large it might be.

There are many reasons behind the resilience of these markets, including strong Quantitative Easing by central banks, and the bond market which, given the low yields, is no longer competitive with the risky market. In addition to this, there is also the new phenomenon of Robinhooders, i.e., the great mass of small American traders who, during the pandemic, began to speculate on the stock market through the Robinhood platform, and who today represent an important part of the U.S. stock market (in June 2020 there were ten million users).

Let's try to understand with some historical charts if this "excessive" bullish market trend has already happened in the past. Let's take the historical data of the S&P 500 index since 1935 and add an indicator that shows us when we are in the presence of situations of excessive upsides that can become unsustainable. This type of indicator shows us in percentage terms how far prices are moving away from their 200-day moving average. Distances (highlighted in red), over 10% (level 0,1 indicated with a red dotted line), indicate a certain level of attention.

As we can well notice from the past situations, the penetration in the red zone has subsequently implied a form of correction whereby the index has fallen again to reach its moving average. However, we can see that this has not always happened immediately, and the indicator has remained in the red zone for quite some time. In this last case the indicator has been in the red zone not for a long time, and among other things we can observe that the extreme movements of this recent period, including the big fall of February 2020 (see the two black arrows in the chart), have been more contained compared to other situations in the past.

More information can be gathered with a more recent historical chart, starting from 2007, and adding a second indicator that explains what is happening in the market in terms of buying and selling volumes: volume, in fact, contains useful information about market sentiment that is not always fully reflected by price information. The indicator is called On Balance Volume (OBV), and it measures buying and selling pressure as a cumulative indicator that adds volume on up days and subtracts volume on down days. It was developed by Joe Granville and introduced in his 1963 book, Granville's New Key to Stock Market Profits.

The data used for this indicator are those of the volumes on the SPDR S&P 500 ETF, one of the most liquid Exchange Trade Funds, which is used by professional and retail investors to invest by replicating the S&P 500 index in a passive way. We are interested in the fact that this indicator, at the moment in which an upward trend in prices begins, also rises, thus confirming that the rise in prices is accompanied by increased pressure on volumes from buyers: a rise in prices without a confirmation of increased volumes is generally rather fragile.

In this latest rise, compared to those that occurred in 2009 (point b) and 2011 (point c), we can see two differences: the OBV in the two previous rises rose, while currently has a lateral trend contained in a channel. The indicator that measures the distance between price and moving average does not make new highs, but moves horizontally, so the price relative to the moving average is rising, but not so quickly as to distance it. This indicates a virtuous equilibrium situation that could continue for some time: how sustainable it is we will be able to evaluate only by continuing to verify the future data that we will receive from these two indicators, especially from OBV: in case it breaks the channel downwards, it would confirm the beginning of a correction.

How large could the future correction be? In theory, not so much. In fact, if we look at the corrections of the S&P 500 index in the last 11 years (blue vertical lines in the following graph), compared with its volatility represented by the VIX, we will notice that all corrections greater than 10%, have developed with a VIX well below 20. The last two corrections, both around 10% (red vertical lines), have occurred with a VIX above 20. Currently, the VIX index does not want to go below this threshold: if on the one hand it indicates that historically the amplitude of the correction should not be large, on the other hand we must remember that a value above 20 represents a situation of strong volatility that, in the presence of further exogenous events, could make the situation worsen very quickly.

In conclusion, we can say that the correction will happen, but given the historical past of the market in similar situations, it is not said that this will happen too quickly. The extent of the correction, considering VIX data, could be moderate. I would not exclude, as a further scenario, a correction replaced by lateral consolidation, with a slight negative trend. However, the presence of a still high VIX should not be underestimated, because in the case of negative events not yet considered by the operators, could lead to a very rapid worsening of the risk market conditions.

We are therefore in the presence of a bullish and resilient market, but that lays its fundamentals on very delicate base: if the current situation will not experience any new and extremely negative events, we will have a tendentially contained correction. Essential will be the movement of the OBV indicator.

About the author

Mario Valentino Guffanti is a board member and Head of the Lugano Chapter. He is a financial advisor, technical analyst and researcher based in Milan, Italy. As an author of technical articles and lecturer as well as instructor in technical analysis courses in Switzerland, he is also dedicated to financial coaching through NLP techniques (neuro-linguistic programming).