These warning signs suggest stocks are heading toward a correction

Published Mon, Feb 22 20211:32 PM ESTUpdated Fri, Feb 26 20219:42 AM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

Several important market indicators are near extreme levels and that means stocks could be heading for a correction, said CFRA chief investment strategist Sam Stovall. "It's not a question of 'if' but 'when,' the next meaningful market decline will occur," he wrote in a research note. One of those signs is the value of S & P 500 market cap compared to nominal gross domestic product. The market capitalization, based on S & P 500 companies, is now at an all-time high of 140% of U.S. gross domestic product, compared to the near 60-year average of 62%. The S & P 500 was down nearly 0.2% on Monday around 1:30 p.m. ET. Stovall also expects the hardest-hit sectors in a correction could be those that have done the best over the past six months, as has historically been the case. Those would be energy, financials and materials. But the hardest-hit sectors also bounce back more than the broader market typically. The warning signs a correction is coming also include sky-high margin debt, which is at an all-time high whether compared to GDP or the S & P 500. The differential between growth and value stocks is also at the highest level it's been in two decades. Stovall looks at the rolling 12-month change for the S & P growth index, less the value index. It hit an all-time high in the third quarter of 2020, and is now the highest since the first couple of months of the bear market that started in the year 2000. Another extreme is the fact that more than 90% of S & P 1500 sub-industries have traded above their 200-day moving average for 15 weeks in a row, which is only the fourth time that has happened in 25 years. Another warning is that all major sectors in the S & P 500, except for health care, are trading at double-digit premiums to their 20-year average price-to-earnings ratio. For the S & P 500 itself, it's at 37%, and the sectors range from 12% to 93%. Stovall said the correction could come in price or time, meaning the market either sells off or consolidates in a sideways move. In the past 25 years, the stock market has corrected 11 times, meaning it has declined more than 10%. During those corrections, the three highest-flying major sectors lost on average 31.7% and the best performing sub-industries lost 43.9%, compared to the average drop in the S & P 500 of 23.8%. As Stovall noted the top three sectors have been energy, materials and financials. The sub-sectors that have done the best recently are agricultural and farm machinery, apparel accessories and luxury goods, auto parts and equipment, he said. Car manufacturers, broadcasting, copper, investment banking and brokerage, real estate services, regional banks and semiconductor equipment have also fared well. Once the sell-off ends, the three hardest hit sectors rose an average 30.6% over the next six months, while the S & P 500 rose just 25.2%. The 10 worst performing sub-sectors rose an average 42.7% in that time frame.

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Several important market indicators are near extreme levels and that means stocks could be heading for a correction, said CFRA chief investment strategist Sam Stovall.

"It's not a question of 'if' but 'when,' the next meaningful market decline will occur," he wrote in a research note.

One of those signs is the value of S&P 500 market cap compared to nominal gross domestic product. The market capitalization, based on S&P 500 companies, is now at an all-time high of 140% of U.S. gross domestic product, compared to the near 60-year average of 62%.

The S&P 500 was down nearly 0.2% on Monday around 1:30 p.m. ET.

Stovall also expects the hardest-hit sectors in a correction could be those that have done the best over the past six months, as has historically been the case.

Those would be energy, financials and materials. But the hardest-hit sectors also bounce back more than the broader market typically.