The Risk Of A Market Correction In 2020 Hits New Highs

The S&P 500 (SPY) has had a record-setting year. After falling -3.5% in 2018 (-18.5% from the 2018 highs) the broad-market index has surged nearly 30% this year. Much of the gains have come in the second half, the index has posted five straight weeks of gains going into the year-end period, and more may be on the way. The traditional Santa Claus Rally period is not quite over, it is possible we’ll see the index post the best run in 22 years.

Despite these stellar figures, there are causes for concerns. A month or so ago I wrote about four reasons investors should start taking profits, since then the situation has only gotten worse.

The Valuations Are Sky High

Valuation is not the best metric for predicting a bull-market correction but it can set the stage. A month ago the S&P 500 was trading nearly 17.5X its forward earnings outlook, it’s now trading more than 19X that outlook. This situation has been caused by two factors, one of which is the December rise in stock prices. The other, more concerning, is the lingering downtrend in earnings outlook. While stock market prices have been rising the outlook for earning next year has been in decline, not a solid foundation for a market rally.

Money Managers Are Preparing For A Correction

The chorus of money managers and institutional investors predicting a market correction has grown in recent weeks. Again, not the kind of information that guarantees a market correction but one that sets up a situation that could result in a self-fulfilling prophecy.

Ed Yardeni, president of Yardeni Research and long-time stock market bull, has become more and more concerned the “stock market melt-up” could result in a major correction. According to him, the market could fall as much as 10% to 20% in the first half of the new year. Yardeni also cites “nosebleed level” valuations and a desire for the market to pullback before putting any new money to work.

Rate-Hike Risk Returns

One of the biggest drivers of stock market prices in 2019 was the FOMC and interest rates. The FOMC began their “mid-cycle” adjustment mid-year, lowering rates to a level that sparked a recovery in housing, and capped the move with a neutral policy outlook for next year. According to Fed Chief Jerome Powell, the market should not expect a rate hike until early 2021 at least. The risk here is that inflation will rebound in 2020 and much quicker than even the Fed can predict.

For one, the Phase One Trade Deal is expected to reinvigorate global economic activity and with it, upward pressure on prices. Although the Fed has said it will take a significant and persistent increase in inflation for it to act the market won’t care. If headline inflation spikes it could easily spark a Fed-related market selloff.

In terms of inflation, wages have been steadily rising at a near to +3% rate for well over a year. Add to this rising commodity prices, notably oil, and upward pressure in the services sector inflation and the odds of CPI moving above 2% are very real. So long as the core consumer-level inflation remains tame, as indicated by the core personal price index, such a scare is likely to be short-lived.

The Technical Picture Is Bleak

Finally, the technical outlook for the S&P 500 is pretty bleak. The market has been melting up so fast this year it has gone parabolic. The index is overbought on every metric that matters and in position for profit-taking, if not an outright correction. At current levels, the index could fall as much as 10% before hitting a level that could be called “solid support”.

In addition to its overbought condition, the S&P 500 is showing significant divergences from MACD momentum that point to underlying weakness within the market. When it comes to technical signals in the MACD the divergences and convergences are the most powerful. Convergence with MACD in the first half of the year predicted the break out to new highs, the divergence in the second points to a correction that could take the market down more than 20% and back to its secular trend line.