S&P 500: Pause or bigger pullback ahead?
A streak of relative stock market calm came to an end with the S&P 500’s worst one-day decline since December 2022.
Following earnings from members of the “Magnificent 7” and growing political uncertainty just ahead of November’s elections, the S&P 500 fell over 2% on Wednesday last week.
That ended a streak of 356 trading sessions in which the S&P didn’t experience a daily 2% decline or more. That was the longest stretch without a 2% drop since one that ended in 2007 as you can see in the chart below.
It also illustrates how mega-cap stocks can drive the major indexes in either direction. Up to June 30, the Mag 7 accounted for 61% of the S&P 500’s 15% year-to-date return. But since July 10, most members of the Mag 7 have fallen as much as 5% or more. Nvidia (NVDA) has even tipped into its own bear market with a 20% decline off the intraday high set on June 20.
And over a two day stretch last week, the Mag 7 collectively lost nearly $1 trillion in market value. The chart below tracks the Mag 7’s market capitalization over the past year, and the daily change in the market cap in the bottom panel.
That has investors on edge if a new regime of higher volatility is creeping back into the market. But even in bull markets, pullbacks and corrections are a normal part of the uptrend.
Using data since 1928, the chart below shows how often pullbacks, corrections, and bear markets come along for the S&P 500. The S&P averages seven dips of 3% every year on average and a 5% pullback three times a year.
So the key question for investors now comes down to the current 5% pullback (which is the second 5% pullback in 2024), and if a normal intra-year decline risks becoming a larger drawdown. In order to answer that question, I’m tracking several charts that should provide an early warning if more downside is ahead.
Here’s a breakdown of three charts I’m tracking to signal if the pullback in the S&P 500 will stay contained, or if a larger drawdown in the stock market is coming for investors.
Bull Market Pause, Or Something Worse
Following the sudden jump in stock market volatility, there has been a quick reversal in bullish investor sentiment as the outlook gets called into question. Expect plenty more noise in the week ahead, so this is when it helps to objectively analyze charts and layout key levels that could warn of more downside.
The first is with the S&P 500 itself and key chart levels. The chart below shows the S&P going back a year, and you can see that the index is coming up to the first couple key support levels. That includes the 50-day moving average (MA — black line), but there’s also price support around the 5400 area which is shown with the shaded box.
That area includes a gap over the 5400 level back on June 12. Price often comes back to test or “fill” price gaps, which is what the S&P did with the failed undercut of the 50-day MA this past Thursday.
Near-term, that makes the 5400 level the first key support zone to monitor. If that fails, then I would expect the next major area of price support at the 5200 level. It’s also worth noting in the chart above that the MACD in the middle panel is resetting at the zero line and the RSI in the bottom panel bounced off 40. Both levels on those technical indicators can serve as support in an uptrend.
As volatility picks up, I’m also watching the action in the CBOE Volatility Index (VIX). The VIX tracks implied volatility for the S&P 500, and has a long-term average of around the 20 level (dashed line in the chart below).
When the VIX is under 20, that can signal a low vol regime and vice versa when the VIX makes a sustained mover over the 20 level. I took the chart back several years so you could see the transition from a high vol regime in 2022’s bear market back to a low vol regime when the VIX shifted back below 20 in early 2023. Even during late 2023’s 10% correction in the S&P 500, the VIX could not sustain above a move over 20.
High and low vol regimes also create a feedback loop with risk parity and volatility targeting strategies, which are popular among institutional investors. These strategies target a constant volatility level, so when VIX is increasing these strategies tend to sell equities.
Selling pressure can then push VIX higher still, creating a negative feedback loop for stock prices. The recent selloff in the S&P 500 has brought VIX just below the 20 level, making it a key level to monitor.
Finally, I’m also watching if the pullback in equities is spilling over into other areas of the capital markets, especially in the high yield bond sector. That includes exchange-traded funds (ETFs) tracking the sector like HYG. The chart below shows the total return for HYG going back a year. You can see that HYG is trading sideways since the S&P 500 and Nasdaq started selling off, which is a positive sign.
I’m also tracking high yield spreads, which is the cost for companies to issue high yield debt over a comparable safer fixed income security like U.S. Treasuries. Since companies issuing high yield bonds are already on shaky financial ground, that makes spreads sensitive to the outlook for economic activity. You can see in the chart below that spreads have stayed contained and are near their lowest level of the past decade.
Near-term, there are key chart levels to monitor on the S&P 500 that can tip if there’s more downside ahead. And if there’s a larger decline ahead, then the action in the VIX Index and high yield bonds should confirm a deteriorating outlook, which isn’t the case at the moment.
Now What…
If the July peak in the S&P 500 holds and the ensuing 5% drop is a sign that the stock market is entering a new bearish trend, then this would have been a relatively short bull market.
You can see in the chart below that the average bull market tends to last for 61 months. Also in bull markets since 1950, the S&P 500 averages a return of 158%. The current bull is only 21 months old with the S&P 500 up 51% since bottoming in October 2022.
I also believe several long-term bullish catalysts are in play that can drive the stock market higher. Those include the liquidity cycle, earnings growth, and decade seasonal patterns that I recently outlined in a report and can keep driving the bull market over the next 12 to 18 months.
And the problem of narrow stock market participation in the first half of 2024 is quickly resolving itself. Since June’s CPI inflation report came out, there has been a surge in new 52-week highs across the stock market and triggering of several breadth thrusts.
Even on the day the S&P 500 dropped 2% last week, 165 stocks still managed to close the day higher. That is is the largest number of stocks moving higher on a 2% down day for the S&P 500 going back at least 10 years (chart below).
And before investors start attributing breadth thrusts to some sort of technical condition in the stock market, it’s worth remembering that stocks follow earnings over the long-term.
The Mag 7 were a big driver of earnings recovery early on in the bull market, and their share prices reflected that. But earnings in the average stock are projected to inflect sharply higher in coming quarters.
The chart below shows year-over-year quarterly earnings growth in the S&P 500 large-cap index compared to the S&P 600 small-cap index. Earnings growth in small-caps are recently turning positive, with growth expected to accelerate into next year.
Stock prices discount future business conditions and earnings, and I believe the surge in small-caps and the average stock is a vote of confidence in the earnings outlook in the chart above. That’s especially the case given recent evidence that looser monetary policy is likely on the way.
And when it comes to trading opportunities, I’m also seeking companies with strong historical and projected earnings growth, and whose chart setup is showing constructive basing action like the stocks highlighted in Mosaic Chart Alerts.
You’re seeing that with MNDY, which is expected to grow earnings per share 26% this year and 23% in 2025. Quarterly sales growth has averaged 37% over the past four quarters as well. The chart below of MNDY is also creating a breakout setup. The stock took out resistance around the $235 level in May then pulled back to the top of the gap area. The stock has tested resistance near the $250 level a couple times, while the stock is making a smaller pullback on the most recent test. I’m now watching for a move over $250.
That’s all for this week. The coming week features plenty of events and data releases to drive further volatility. We remain in the busiest period for earnings releases, with companies like Amazon, Apple, and Meta reporting this week. We also have the latest Fed rate setting meeting on Wednesday, and the July payrolls report on Friday. But I’ll be following the charts laid out above to cut through the noise.
I hope you’ve enjoyed The Market Mosaic, and please share this report with your family, friends, coworkers…or anyone that would benefit from an objective look at the stock market.
For updated charts, market analysis, and other trade ideas, you can visit me here: www.mosaicassetco.com
Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this report.
