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Stock Markets Set to Pop and Drop?


Sit tight, be cautious -- and hope stocks realign with reality.

I've written a fair bit over the past few days about the overbought level of most global stock markets and also how China -- a leading market on the way up -- could be the catalyst for triggering a reversal of fortune. It would seem the expected downward correction is now squarely under way, with the MSCI World Index down by 3.4% and the MSCI Emerging Markets Index 5.2% lower since their respective highs of August 13 and August 3.

A summary of the movements of major global stock markets since the recent highs, as well as various other measurement periods, is given in the table below. Interestingly, none of the indices in the table have been able to withstand the downdraught, with the Chinese Shanghai Composite Index (-17.3%) and the Russian Trading System Index (-10.0) leading the way down -- in not dissimilar fashion to how these indices blazed a trail to record rally returns of 90.7% and 95.4%, respectively.

I discussed valuation levels and technical sell signals in my recent posts, but another factor that could come into play is seasonality turning negative. Focusing on the S&P 500 Index and the Dow Jones Industrial Index, I've done a short analysis of the historical pattern of monthly returns for these indices from 1957 to mid-2009. The results are summarized in the graph and table below.

If one looks at the average return per month and in which months the most market declines have occurred, it seems as if the months of June, August, and September are traditionally bad for stock markets. Although June this year played according to script, with the S&P 500 showing a zero return and the Dow Jones declining by 0.6%, July excelled with 7.4%/8.6% gains. Given the overbought level of markets, it's conceivable that the "bad" months of August and September might conform to the historical pattern. September, specifically, has over time been the month with the lowest average monthly return.

The much-needed correction of the summer rally could take the form of either a pullback or a consolidation (i.e. ranging). I suspect we may see at least some degree of reversion to the 200-day moving averages in a number of instances, but will be watching closely to ascertain whether we're dealing with a normal short-term correction or a more significant move threatening the primary trend. In the meantime, sit tight and be cautious as markets hopefully realign with the reality on the ground.
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No positions in stocks mentioned.
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