The S&P 500 has broken through support, which is an old resistance areas from the 2018 and earlier 2019 highs. On July 18 the following chart was posted of the S&P 500. At that time the S&P 500 was in an uptrend, and currently still is.
The drop through support is important, though, since it means a bigger correction is underway.
Minor corrections are typically 7% to 10%. During the run higher in 2017 we saw lots of corrections of about 3%, but we have already exceeded that so we can rule this situation out as one of the 3 percenters. The percentages measure the high in the index to the recent price or low before the price starts moving higher again.
On the chart, a box has been added showing where the 7 to 11.5% pullback area. This is the most likely reversal area. If the price reaches the lower end of that box, the uptrend is no longer in play based on price action, because the index will have created a lower-low (relative to the June 2019 low).
20% pullbacks are less frequent. We saw one in 2018 and it was rapidly reversed. Another box is drawn lower on the chart showing where the 20% correction area is. It is near the 2018 low.
Since the 1920’s there have only been three 50%+ corrections in a major index like the S&P 500. One in the 1920/30s, 2000, and then in 2007/08. Therefore, these types of market crashes are rare, but they hurt and take several years to recover from. A box has been drawn on the chart to show where a 50% correction would take us.
What To Do With This Information
Your trading plan should tell you what to do based on what the market is doing.
For me, while I do expect the price to possibly head a bit lower, I am still watching for strong stocks to buy. I watch for the stocks that hold up while the index is falling. When those stocks start moving up, I buy them.
When the index moves into a downtrend, I become more cautious, and may only deploy half the capital into each position that I usually would. We aren’t in a downtrend yet, but it could happen relatively soon.
I also watch the areas on the index that I pointed out. Most corrections are 7% to 10%. Once that area is reached, I watch for the index to turn higher. If and when it does, I am also on the lookout for strong stocks to buy. At the 20% correction level, once the index turns higher, I get very interested in buying the stocks that have held up during the decline.
A decline below 20% means something big is going on. Best to sit back and watch it play out with money on the sidelines ready to be deployed. That unlikely situation will be discussed further at a later date, if needed.
For the more passive investor, the target areas represent areas to potentially put more capital to work. In my retirement account, I do some stock selection but I mostly stick to buying index ETFs. For the S&P 500, I will add to my positions when the index corrects between 7% and 10%. I will add more if the index drops 18% to 20%. I buy as much as I can (UNleveraged, and not taking away from my swing trading or day trading capital) if the index drops 40% to 50%. This is my strategy, and not a recommendation for others to do it. It works for me because I regularly contribute to the account and therefore have capital available to buy at these different junctures. I also have a long investment horizon, so I don’t mind being offside on my recent purchases for a few months or a few years. Since the indexes have historically continued to rise, eventually the corrections no longer reach the prior purchase prices.
I don’t view buying on the decline, in an index like the S&P 500, as averaging-down. It is absolutely averaging down, but I am also averaging-up, because I continually add to my position on corrections when the price is moving up, overall, as well. Also, since the S&P 500 has continually moved higher over the decades, it makes sense to buy at regular intervals. Buying an individual stock as it drops isn’t as smart, since an individual company could go bankrupt or never recover from a share price decline.
The S&P 500 is still in an uptrend, but because it broke support we could see a bigger decline. A 7% to 10% decline is most likely. A near 20% decline is less likely, but could occur.
In both cases, I will be recording which stocks are holding up the best. I will be looking to buy them as swing trades if they start to move up again. Once the index declines more than 10% to 12%, I usually scale back my position sizes, especially if the index made a lower swing low (no longer uptrend).
From a passive investing perspective, I will be adding to my index ETF positions at the target areas.
By Cory Mitchell, CMT