A market correction isn’t too far away & it’s likely to feel pretty severe

Right now sentiment among stock investors is extremely bullish, and history shows that when sentiment becomes this one-sided a market correction usually isn’t too far away. Although the correction is only likely to be around 15%, it is likely to feel much more severe.

On Friday Felix Zulauf, Founder and President of Zulauf Asset Management AG, noted that the sentiment among stock investors is “as optimistic as it was in 2007”.

Felix, who has been a member of the Barron’s Roundtable for over 20 years, went on to say that he thinks that “we have entered very dangerous territory. We are not out of the woods yet and the market is very euphoric, and that creates a very dangerous combination, because the market is expecting something that the real world will not be able to deliver.”

Felix thinks that equity markets are living on borrowed time and that we are “building a top”. He notes that the number of stocks making new highs is declining, and that the number of markets around the world that are trading above their 200-day moving averages is also declining. He also believes that “the world economy will not deliver what people expect”, and predicts that the Eurozone will contract by as much as 2% in 2013.

Another respected market analyst, Tom McClellan, son of Sherman McClellan (the inventor of the McClellan Oscillator), commented last week that “when you see the price chart get very linear, that’s a troubling sign because it means that there is an absence of worry. Everybody is feeling fine, nobody feels like rocking the boat, it’s all just wonderful. Those very linear moves tend to be followed by dramatic nonlinear moves when they reverse… and we’re in that condition.”

He goes on to say that, “Sentiment is hugely bullish right now. All the newsletter writers that Investors Intelligence tracks are bullish, the AAII surveys are all bullish, the put call numbers are really bullish, the TV anchors on CNBC are all really bullish, everything is really bullish and we are waiting for that to start to matter. We just have not yet had that spark that is going to kick the market out of this very tight uptrend.”

A 6 month daily chart of the S&P 500 (Click on the chart for a larger version)

A 6 month daily chart of the S&P 500 (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

How severe will the market correction be?

In 2010 we got a 17% correction in the S&P 500, in 2011 it was 21%, and in 2012 there were two smaller corrections of 11% and 9%. One possible scenario (which is shown on the chart below), is that the S&P 500 continues higher but runs into resistance at its all-time high at around 1,576. Failure to breach the previous high could be the trigger for the bulls to turn bearish, and as Tom McClellan stated in his interview, once the selling starts, “I think you are going to see a rush to the exits as people try to get out ahead of the other guy, because it’s been looming for a long time and a lot of people know it”.

History shows that investor psychology can turn on a dime and this market looks poised to have what Tom refers to as an “overly scary reaction”, meaning that the correction will feel worse than it actually is.

One area where the market might find support is at the November 2012 low of 1,343. This would represent a 14% correction (purple arrow), in our view this will be a normal healthy correction within the context of an ongoing cyclical (liquidity fuelled) bull market.

A 6 year daily chart of the S&P 500 (Click on the chart for a larger version)

A 6 year daily chart of the S&P 500 (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

It’s worth noting however, that if we don’t see a market correction soon, it’s possible that the market will take on unhealthy characteristics similar to those seen prior to the 1987 crash, but we are not looking at that scenario yet.

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