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Will Markets Retreat 10 Percent -- or More?


Now is the time for a defensive position.

The venerable Richard Russell of Dow Theory Letters fame said:

"In order for a counter-trend rally in a bear market to be sustained, it requires steady or rising buying power plus short covering. Lowry's Buying Power Index has been declining steadily since May 8. At yesterday's market close, this Index (demand) was only 24 points higher than it was at the March 9 lows. Furthermore, volume is drying up.

"This is extremely negative action. Whenever buying power contracts during a rally in a bear market, the prevailing primary bear market forces immediately take over. For that reason, unless the trend of declining buying power soon halts and reverses, I believe that the March 9 lows will be attacked and violated."

For more about key levels and the most likely short-term direction of the S&P 500, Adam Hewison of prepared another of his popular technical analyses. Click here to access the short presentation.

What about valuations? In order not to work with notoriously unreliable forward-looking earnings estimates, I prefer using Robert Shiller's cyclically adjusted price-earnings ratio (CAPE), or normalized earnings as they average 10 years of earnings. This measure provides a good picture of the market's value regardless of where we are in the business cycle. On this basis, the multiple increased to 15.8 during the rally compared with a long-term average of 16.3. This represents "average" value at best.

I argued in my post of 2 days ago, Have Stock Markets Run Away from Valuations?, that based on the historical relationship between the Purchasing Managers Index (PMI) and stock-market movements, the S&P 500 seems overpriced under all scenarios over the next few months. It only reaches positive territory again in August under the "very optimistic" scenario and in November under the "optimistic" scenario.

It's difficult to envisage how much of a pullback we might see. I'd be surprised if the retreat isn't at least 10%, but don't exclude a bigger and longer correction than what many pundits are expecting. At this juncture, my advice will be to assume a defensive position in your investment portfolio.
No positions in stocks mentioned.
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