We’re In the Process of a Correction

Dear Reader,

Here we go again folks…

After losing 3% yesterday, ASX 200 futures suggest our market will open down another 3% today. My guess is it will finish worse than that.

The cause, of course, is the renewed plunge in US stocks overnight.

The Dow crashed nearly 7%, the S&P 500 nearly 6%, while the NASDAQ fell just over 5%.

While gold outperformed, falling less than 1%, gold stocks didn’t escape the carnage. Major gold equity indices were down between 5–7%.

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What’s going on?

It’s pretty simple. Markets went from being overly bearish in March to insanely bullish just a few months later.

It was purely speculative, based on hope and ample Fed liquidity. And when I say insanely bullish, I mean it.

I mentioned Hertz car rentals yesterday. It filed for bankruptcy protection, then rallied nearly 1,000%. But after peaking at around $5.50 on Monday, it’s now back around $2.

That’s $2 more than it should be, but still, the move is emblematic of an insane market.

When things get like that, you have to keep your head and not play along.

I encouraged readers of my Crisis & Opportunity newsletter to do just that earlier this week, by pointing out the risk/reward trade-off for the market was poor.

‘…the recovery rally is nearly ALL emotion and liquidity. In the same way that the market fell too far, too fast, it has now rallied back too far, too fast.

There will almost certainly be a reaction to the downside. Just when that happens though, I don’t know.

All I know is that the risk/reward trade-off for the market now is poor.  

For example, if this virus is a real threat, the risks of a second wave of infections just escalated enormously with the protests that took place around the world on the weekend.

That governments shut the global economy down for months to ‘stop the spread’, but then allowed tens of thousands to congregate while small business continued to bleed, is an absolute disgrace.

So now there is a very real risk the virus will resurface. Markets are not pricing that in at all.

There’s also the fact that government income support will start dropping off in September, if not sooner.

One of the bizarre things about this period is that generous government support, and the ability to defer mortgage payments, has actually led to a boost in disposable incomes.

But it’s a short-term boost. Again, just when the market decides to price in this reality is anyone’s guess.

Well, it sure looks like it might be starting to price it in now.

Starting is the operative word here.

How big will this correction be?

Let’s look at the S&P 500 first…

As you can see in the chart, the corona crash soon turned into a miraculous recovery. But as I said, it was a rally built on emotion and liquidity. So how far could this correction take us?

Using Fibonacci retracement levels as a guide, there are three different scenarios that could play out. From top to bottom, the market could fall 5%, 9% or 13%.

My guess is that we go on to test the 50% level at least, which suggests another 9% downside from here.


The Rum Rebellion

Source: Optuma

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But how it all plays out depends on whether we get a second wave of the virus, and what the response is if we do.

That’s what investors are starting to fear now, as the Wall Street Journal reports:

Growing fears of a surge in coronavirus infections sent the stock market tumbling Thursday, pulling the Dow Jones Industrial Average down more than 1,800 points for its worst day since March.

For months, investors have been betting the U.S. and other countries will be able to reopen their economies without seeing a spike in coronavirus cases that might force them to backtrack. Stocks have risen accordingly, with the S&P 500 turning positive for the year as recently as Monday.

But in the past few days, investors have gotten more signs that the smooth reopening they have been hoping for may be increasingly difficult to achieve—throwing into doubt their hopes for a nascent economic recovery.

How does it look if we perform the same analysis on the Aussie market? Here’s a chart of the ASX 200…

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Not including today’s move, the potential declines you could see in the weeks ahead are around 7%, 13%, and 16%.


The Rum Rebellion

Source: Optuma

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Of course, this all assumes markets won’t break down to NEW lows.

I think that is a low probability outcome at this point. Not impossible, just low probability. In investing, you have to play the odds, so I’m running on the resumption this is a correction and part of the general bear market we are in.

There’s one more chart I want to show you. It’s one I showed to readers of our subscriber-only Insider publication last week. (If you’re a subscriber to any of our services, access to The Insider is complimentary. You can get it by clicking here).

Anyway, the chart is the Small Ordinaries Index. Small-caps have been on a tear since the March low. It tells you investor risk appetite is back. Last week, I highlighted the risk of this leading small-cap sector hitting resistance and turning back down…


The Rum Rebellion

Source: Optuma

[Click to open in a new window]

Well, the index hit that resistance level intra-day on Tuesday and did exactly that. I think there is a good chance that prices fall back to the lower green line AT LEAST. That would represent a 13% decline from top to bottom.

If we’re in a bear market and the economic recovery is slow (following the removal of a lot of government support), prices could fall much further.

To sum up then, we’re in the process of correcting the big rally of the past few months. But I don’t think we’ll make new lows.

With this in mind, it’s a good time to remember the old adage about being greedy when others are fearful…

Regards,


Signature
Greg Canavan,
Editor, The Rum Rebellion


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own. Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts. At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates. Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.


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