The S&P 500 has slid for three straight sessions, and strategists say the drop could be the start of something bigger. Stretched valuations, extreme bullish sentiment, and cooling earnings momentum are fueling forecasts of a 10% to 20% correction before the end of the year.
The S&P 500 has fallen for three straight trading sessions through Tuesday, a slide analysts say could be an early sign of a larger pullback. Jim Paulsen, an economist and former Wall Street strategist, projects a possible 10% to 20% correction before year-end. Stretched valuations, extreme bullish sentiment, and slowing earnings growth are among the reasons cited for caution.
Seasonal weakness looms
September is historically the worst month for the S&P 500, falling about 1% on average since 1928. That modest average hides how many serious pullbacks cluster in the month. October tends to finish stronger, but the yearly low for stocks typically arrives around Oct. 10-12.
Bullish extremes flash a warning
Investor sentiment looks stretched. The Investors Intelligence Bull/Bear ratio recently stood at 3.88 on a scale of roughly 0.5 to 5, and readings above 4 have historically signaled a need for caution. The index itself recently traded 55% above its postwar trend-line average, a premium exceeded only at the peak of the dot-com bubble in March 2000.
Defensive stocks have fallen out of favor too: their share of S&P 500 market cap slipped to 17%, near a record low. A Bank of America bull-and-bear gauge recently read 9.6 on a scale of 10, a level the bank treats as a sell signal.
Earnings expectations look overstretched
Wall Street's optimism extends to earnings. The 12-month forward consensus EPS estimate for the S&P 500 sits nearly 90% above the trailing 10-year average reported earnings, against an average premium of just 32% since 1990.
Savita Subramanian, head of U.S. Equity & Quantitative Strategy at Bank of America, agrees: "Historically, lofty long-term growth expectations have been a bearish setup". Her bank's models point to 7% downside risk for the S&P 500 over the next 12 months.
Momentum is fading
An unexpected loss of 23,000 jobs in July, reported Aug. 7, may be an early sign the economy is losing steam. Paulsen says forces like the strong dollar, high oil prices, and rising Treasury yields typically weigh on growth with a lag of six to 12 months, and those forces have been building.
Earnings-growth momentum is cooling as well: third-quarter EPS estimates recently rose 0.89%. That's down from the 1.16% increase that followed first-quarter reporting.
Paulsen isn't forecasting a recession, since household and business balance sheets remain strong. Instead, he expects a stretch of scary recession fears intense enough to trigger an S&P 500 correction and a technology-sector bear market before the end of the year.
Source: MarketWatch
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