A rapid and strong rally in U.S. stocks took a pause on Wednesday, with major indexes experiencing their largest drop in months. This downturn was seen as a welcomed development by bulls looking for a chance to refresh a market that had become stretched.
On the other hand, bears argue that this pullback is likely evidence that the market rally was built on shaky foundations.
The Dow Jones Industrial Average (DJIA) fell by 475.92 points or 1.3% on Wednesday, marking its biggest one-day percentage drop since October 3. This put an end to a streak of five consecutive record finishes. The S&P 500 (SPX), which had been rallying and came within 1% of its record close on January 3, 2022, retreated by 1.5% to just below 4,700. This was the S&P 500’s biggest percentage decline since September 26. The Nasdaq Composite (COMP) also experienced a 1.5% drop, its largest since October 26.
Both the Dow and Nasdaq had been rallying for nine consecutive days prior to Wednesday’s setback. This impressive rally, which had accelerated from the October lows, caused major indexes to become significantly overbought according to technical indicators, analysts explained.
Market economist Ed Yardeni from Yardeni Research pointed out, “Most pundits concluded that the market was overbought and due for a correction. We agree, which is why we haven’t raised our longstanding year-end target of 4,600.” Yardeni remains bullish in the long term and forecasts the S&P 500 to reach 6,000 within two years.
In addition to technical indicators, sentiment among investors had also turned extremely bullish based on surveys.
However, technicians note that high levels of bullish sentiment are not as reliable of a signal for market tops compared to heavy bearish sentiment indicating market bottoms.
Embrace Weakness: A Technical Analysis Perspective
Technical analyst Jeff de Graaf, chairman of Renaissance Macro Research, has released a note titled “Embrace Weakness,” expressing his views on the current market trends. According to de Graaf, a setback in an uptrend with momentum presents an opportunity for investors to buy.
In his analysis, de Graaf showcases a chart that compares future returns for S&P 500 futures (ES00) with the Consensus Inc. measure of sentiment. He points out that sentiment measures indicate a higher bar for bearishness.
However, de Graaf remains confident in his stance that any weakness in the market, expected to be within the range of 3-5%, is a favorable buying opportunity for those with a six-month investment horizon.
On the contrary, bears anticipate further weakness in the market. Michael Kramer, founder of Mott Capital, expressed his concerns in a recent note. Kramer believes that the entire rally has been built on unstable ground and attributes the potential fall of the S&P 500 to 4,100 over the next few weeks to this shaky foundation.
Kramer also highlighted the expiration of options contracts on the Cboe Volatility Index (VIX) as a contributing factor to the recent selloff. Options activity had previously suppressed the VIX, which is often referred to as Wall Street’s fear gauge. Furthermore, Elliott Wave analysis, a popular form of technical analysis that focuses on market wave patterns, suggests an approaching peak.
While Kramer cautions against making premature downside calls, he notes that there are signs of better alignment this time. The VIX is moving higher, and the S&P 500’s overbought conditions have reached their limit in recent days. Considering these factors, Kramer suggests that if this is indeed a market top, it would make logical sense.
In conclusion, both de Graaf and Kramer provide their unique perspectives on the market conditions. De Graaf sees weakness as a buying opportunity, while Kramer urges caution due to concerns about the stability of the recent rally. Investors should carefully analyze these viewpoints and make informed decisions based on their investment goals and risk tolerance.