The S&P 500 may be less than 3 percent away from the record highs it hit at the beginning of March, but a close examination of the charts reveals several pieces of evidence that the recent decline is likely to continue.
For starters, the yield on the 10-year note continues to slide. On Friday, it broke below its four-month range of 2.6 percent to 2.3 percent.
Second, the U.S. dollar/Japanese yen that we've been harping on recently did indeed follow its recent "lower-high" with a "lower-low" last week. As we have said many times in the past, the dollar/yen is a key indicator for the carry trade, in which investors borrow one currency (here, the yen) at a lower interest rate in order to buy another currency with a higher rate (the dollar). As the dollar continues to fall against the yen, those who are in this trade lose money, and the trade becomes less attractive — which, in turn, leaves less liquidity sloshing around in U.S. markets.
Another concern we raised recently is the potential that the SOX semiconductor index had become vulnerable. Sure enough, the SOX fell almost 5 percent last week, but more importantly, it broke below its 50-day moving average, which had been very good support for the index since last June. It now stands 2.5 percent below that line, so this would be considered a meaningful break of that moving average. At this point, if the SOX fails to bounce back quickly and strongly, it's going to be quite negative for the group. And if you're wondering why this matters, just remember that the semiconductor group has been a key leader in the post-election rally.
Speaking of tech, the broader XLK tech ETF also broke below its 50-day moving average last week, but only by a very small amount. If this index follows the SOX lower, it's going to take away an important leg in the bullish stool for the stock market.
Having said all this, we want to be crystal clear: We are not calling for a repeat of 2008 by any means. Pullbacks and corrections are normal and healthy. Since the 2009 lows, we've seen a pullback of at least 7 percent in every year since then — and in most of those years (2010, 2011, 2012, 2015 and 2016) we've seen official corrections of 10 percent or more. And yet the stock market has still been able to rally more than 240 percent from its 2009 lows.
In other words, you should stop worrying about whether pullbacks will happen, because we already know that they will. Instead, you should focus on how to take advantage of the next drop, so that you know what to do once it takes place.
If the market does indeed continue to decline, the key level to keep an eye on for the S&P 500 will be its 200-day moving average, which currently comes in at 2,229. If the S&P can hold the 200-day, as we expect it to, a drop to that level is going to present a quite bullish setup. On the other hand, if the S&P breaks below that moving average in any meaningful way, it should lead to a double-digit percentage decline.
In summary, the recent action in several other markets has been telling us for a little while now that the stock market has become vulnerable to a 7 percent to 10 percent pullback. But instead of worrying about this event, investors should focus on how to take advantage of it. For some, that will mean buying portfolio protection, or even getting short. For others, that will mean raising a little cash, or buying more defensive names.
Either way, doing some preemptive strategizing about how to take advantage of such a correction will likely be the key to success in the second quarter of the year.