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Game Over? Some Pros See 20% Drop in Stocks Ahead

The S&P 500 Index could be headed for a drop of more than 20 percent because of a coming spike in volatility, according to notable chart analyst, Citgroup’s Tom Fitzpatrick.

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The firm’s chief technical analyst warned that the CBOE Volatility Index, which measures the market’s expectations of future volatility, was primed for a significant pop similar to ones that have sent the S&P 500 down 27 percent, on average, over the last five years.

“Every bounce off this VIX support line has been followed by an aggressive correction lower in the S&P in the months that followed,” warned Fitzpatrick, in a note to clients last week. “Such a dynamic IF the trend high for 2012 is already in place would suggest a fall to 1,038 over anything from 5 to 17 months.”

The so-called VIX shot above the 21 level Monday after trending as low as 14 in late March, which was just a few days before the S&P 500 reached its high for 2012. The Chicago Board Options Exchange Volatility Index essentially measures the prices of callsversus putsbeing purchased on the S&P 500 and so a higher index means investor fear is rising.

And Fitzpatrick is not alone.

“At this point in the volatility cycle, we believe each new tremor is incrementally more likely to be the beginning of the next, inevitable shock,” said Jim Strugger, MKM Partners derivatives strategist, in a note Monday. “We think the recent run-up in equity volatility metrics warrants caution even while maintaining the view that the most natural outcome is for the trough phase of the cycle to extend another couple of months.”

Citi’s Fitzpatrick also overlaid a Dow Jones Industrial Average chart from 1973 over this year’s Dow that was eerily similar, and seemed to portend a big drop ahead.

“The 1966-1978 compared to 2000-2012 dynamic remains our number one choice of equity overlays,” wrote the analyst in the report. “A surging oil price, a sharp fall in economic activity and rise in unemployment and a collapse in housing activity all have a strong resonance.”

So what do fundamental investors think of this call?

Brian Kelly, who runs Shelter Harbor Capital, said he’s not ready to sell everything on the Fitzpatrick report yet. The hedge fund manager is watching to see if the S&P 500 can keep its head above 1340, a level it briefly traded below Monday. A significant break below that level could mean Fitzpatrick is right, he said.

“This fundamental scenario combined with the technicals could easily produce a 25 percent decline in the stock market,” said Kelly. “The catalyst for a sustained downtrend is not only political chaos in Europe, but also the twin US headwinds of the fiscal cliffand regulatory implications from the JPMorgan trading loss.”

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