3 Warning Signs A Market Drop Is Coming
In older books about the stock market, there’s a pattern called a “coil.” Precise definitions differ, but the general idea is that the price action is acting like a spring being compressed. Eventually, the spring is released, and it makes a rapid move as it reverts to its full size.
In the market, the coil is a setup for a sharp price move. The chart below shows the recent price action with a volatility indicator at the bottom of the chart.
The indicator is the Income Trader Volatility (ITV) indicator I developed to help me identify the best times to trade options. It’s a pure measure of volatility that responds relatively quickly to the market action. Best of all, it solves the problem of the lag that is found in many popular volatility indicators.
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Currently, volatility is low, as it was in September.
ITV tends to move from low to high values. Current readings are low and that means we should expect it to move higher soon. The chart shows that prices generally decline when ITV moves higher. That’s what I expect to see in the coming weeks.
This is consistent with the forecast I shared with my Profit Amplifier readers — and then later with you in this previous article. Then, I noted that the Dow Jones Industrial Average had closed up eight weeks in a row. Based on how prices behaved in the past after long winning streaks, I expected the Dow to drift higher last week. We definitely saw prices drift, and the index ended the week down just 0.0002%.
In the next few weeks, I expect a pullback as ITV rises. The next chart shows my price target for this decline.
The line is at the 50% retracement level of the recent advance.
A retracement is the normal price action that follows a large move. In this case, the large move was up, which means we should be looking for a retracement down to cover part of that advance. In the late 1800s, Charles Dow noticed that retracements are often half the size of the preceding move. That’s the 50% level I highlighted in the chart.
There is also a small area that provided support and resistance. As prices fell in December, the decline stalled near 2,580. That indicated there were some buyers at that level. In January, the rebound slowed at that same level. That confirmed the price level had some significance.
The confluence of the two techniques adds to my confidence that the price level is significant. It’s now likely we could see decline of about 8% as prices move towards 2,580.
I’m Also Watching The Bond Market
Treasury markets confirm the likelihood of a decline in stocks. Interest rates have been moving up.
Rates are still low. The chart of the 10-year Treasury shows the yield is near 2.75%. The Federal Reserve has indicated they are likely to hold rates steady for the next few months.
However, they will also be reducing the size of their balance sheet.
As the Fed tried to jumpstart the economy after the Great Recession ended in 2009, the Fed bought bonds to increase the money supply. This was part of the quantitative easing strategy that became necessary when short-term interest rates hovered near zero. These bonds ended up on the Fed’s balance sheet, which grew to $4 trillion.
Now, the Fed is working to move those assets off its balance sheet. This is increasing the supply of bonds in the market at the same time the Treasury Department is trying to sell $1 trillion worth of bonds to finance the budget deficit and refinance debt that comes due.
Standard economic theory says that as the supply of bonds increases, interest rates will need to rise to entice investors to buy the bonds. Economists with Deutsche Bank estimate the Treasury rate will increase by about 0.5%.
As rates rise, bonds become more attractive relative to stocks. That often leads to a decline in stocks.
Look Out For The Fed
Rising interest rates are another factor that could lead to a selloff in the stock market. I expect this to unfold over the next few weeks as analysts begin speculating what the Fed will announce after its meeting on March 20. Chairman Jerome Powell will conduct a press conference after that meeting, and that often leads to an increase market volatility.
I’ll wrap this up by highlighting the stock market action after Powell’s last press conference.
At that time, prices fell from the support level I highlighted earlier. The decline was quick and sharp, lasting just one week and resulting in a 9% decline.
It would not be surprising to see prices follow a similar pattern over the next few weeks. We could fall into a narrow range for a few days. But the downside risks are significant.
Action To Take
Now, it is important to note that the correlation of individual stocks to the broad market is decreasing. That means many individual stocks could rally in the next few weeks even if we see weakness in the major market averages. In other words, it should be a great market for short-term traders.
That’s good news for my Profit Amplifier readers. By using our proven system, we’re able to make quick trades on stocks in either direction. What’s more, we’re able to turn moves of just a few percentage points into gains of 10.4%, 58.9%, and even 60% or more in a matter of days. If you’d like to know more about our strategy — and get your hands on what could be the biggest trade of the year — check out this briefing.