Authored by Lance Roberts via RealInvestmentAdvice.com,
In last week’s post, “Is the correction over?” we wrote about the potential for a rally back to the 200-DMA. However, the failure of that test increased short-term concerns. As we noted in that post, there were early indications of buyers returning to the market. To wit:
“The chart below has four subpanels. The first is a simple price momentum oscillator. This measure is currently deeply oversold after the recent bout of selling and, like the MACD, is beginning to turn higher. That signal is confirmed by the following two indicators, which measure the volume and breadth of the market (are transactions increasing along with more buyers than sellers). With those two indicators also increasing and the number of stocks on “bullish buy signals” rising, the early clues of a market bottom are appearing.”
However, while the trading action early last week was encouraging, the announcement of additional tariffs and ongoing “trade uncertainty” from the White House reversed those early gains. Most notable was the failure of the market to hold above the 200-DMA, which has increased the risk of a continued market correction or consolidation process.
Previous History
Historically, failures at the 200-DMA have elicited heightened concerns from investors. Technically speaking, “nothing good happens below the 200-DMA.” Still, over the last 30 years, previous failures at the 200-DMA have often been buying opportunities. That is unless some “event” of magnitude creates a massive shift in analyst’s estimates.
For this chart, I label “bear markets” as periods when the market fails the 200-DMA and repeatedly fails subsequent retests of that moving average. If the market fails at the 200-DMA and recovers shortly thereafter, it is considered a “correction.” As shown, during the first two “bear markets,” earnings fell sharply as the economy slowed and a recession took hold. Outside the brief “Covid” pandemic, earnings remain well anchored to ongoing economic growth. If the current failure at the 200-DMA is the beginning of a deeper market correction, we should see earnings estimates beginning to fall more quickly.
What is notable is that previous to the massive Federal Reserve interventions beginning in 2008, bull and bear markets were well defined by the 200-DMA. However, post-2008, repeated interventions have kept the market from entering deeper valuation-reversion cycles. More often than not, since 2008, investors have been rewarded by “buying the dip” during corrective periods.
Is this time different? Are we entering a more significant corrective cycle? The outlook for earnings by Wall Street is the key we want to watch closely.
The Outlook For Earnings Is All That Matters
As we discussed in the latest #BullBearReport, the recent corrective action in the market has been driven by a short-term “tariff” narrative rather than the realization of a negative shift in economic activity.
“That catalyst turned out to be President Trump’s “on again, off again” tariff announcements, which created turmoil in earnings expectations. The flux in tariff policies makes it difficult for markets to predict future earnings and corporate profitability. With the “E” in forward valuation measures in flux, markets struggle to price in expected outcomes.”
This is why, while we see minor tweaks to previously very optimistic earnings estimates, expectations for 2025 and 2026 remain very bullish. As noted, during previous “bear markets,” earnings sharply declined as either a financial event or recession reduced consumer spending drastically. Currently, earnings estimates remain well above the long-term growth trend and show little sign of deterioration so far.
The focus on earnings is because both earnings and forward estimates reflect changes in the market’s assessment of the risk of all other events. Investors often get lost in the media headlines about rising recession risks, debts, deficits, or valuations. While those risks are important, they are terrible for predicting where markets will likely move next. Furthermore, if or when those risks become an issue, the market will begin to reprice for a reduction in forward earnings.
This is why the markets tend to be a leading indicator of economic recessions, as the change in earnings and forward estimates reflects changes to the economy in real-time. We discussed this point in “Economist Expect A Recession.”
“The chart below shows the S&P 500 with two dots. The blue dots are when the recession started. The yellow triangle is when the NBER dated the start of the recession. In 9 of 10 instances, the S&P 500 peaked and turned lower before the recognition of a recession.“
The Best Indicator
As noted, given that slowing economic growth, a contraction in consumer demand, or economic policies that directly impact earnings (like tariffs) are quickly factored in by Wall Street into forward estimates. Given that investors value the market based on future earnings, it’s no surprise there’s a clear correlation between the market and earnings.
Looking at forward estimates, while there has been a minor cooling in the previous exuberance, analysts still expect a 16% annualized growth rate in earnings into next year. Unless those estimates begin to reverse sharply, it is unlikely that the current correction will devolve into a deeper corrective cycle.
We see the same correlation when comparing forward estimates to the market. Deeper corrections correlate to a reduction in forward operating earnings, which currently does not exist.
Could that change? Yes, which is why we watch the changes to earnings estimates closely. If analysts begin to factor in risks of a deeper economic contraction, a tariff-related impact, or some other financial event, then the risk of a more profound correction increases. However, the recent market failure does not indicate a larger corrective cycle, given the lack of more drastic negative earnings revisions—at least not yet.
However, if you are looking for a warning signal, the weekly data is sending a warning.
Repeating 2022?
The chart below is a long-term weekly chart of RSI and MACD indicators. I have denoted when the indicators are trading in bullish and bearish trends. The primary signal is the crossover of the weekly moving averages, as noted by the vertical lines. While the MACD and RSI indicators provided early warning signals, the moving average crossover confirmed a market correction or consolidation. These indicators will not necessarily cause a risk reduction precisely at the top. However, they generally provide sufficient indications to reduce risk ahead of more significant market corrections and consolidations.
Conversely, they also offered signals when investors should increase market equity risk. These signals were instrumental in avoiding the 2008 market crash and the 2022 correction. Currently, the RSI is crossing below 50, which may suggest a continued correction process with the MACD beginning to revert. However, the moving average crossover has not yet confirmed the RSI and MACD messages.
The market tells us that the risk of a more significant correction or consolidation process is increasing. While such does not preclude a significant counter-trend rally in the short term, the longer-term risks seem to be growing.
If we enter another corrective period like 2022, given some of the same technical similarities, there is a decent “playbook” to follow despite substantial differences. In 2022, the Fed was hiking rates, inflation was surging, and economists were convinced a recession was on the horizon. As noted above, earnings estimates were revised lower, causing the markets to reprice valuations. Today, the Fed is cutting rates, inflation is declining, the risk of recession is very low, and estimates remain optimistic. However, we must realize that the analysis can change as time passes.
In March 2022, the market triggered the weekly “sell signal” as it declined. Notably, the market rallied sharply higher after the “sell signal” was initially triggered. This is unsurprising, as when markets trigger “sell signals,” they are often profoundly oversold in the short term. However, that rally was an opportunity to “reduce risk,” as the failure of that rally brought sellers back into the market. The “decline, rally, decline” process repeated until the market bottomed in October.
Suppose the recent failure at the 200-DMA begins a larger corrective cycle without the onset of a financial event or deep economic contraction. In that case, we should most likely expect a similar reversion process. As noted above, that correction process will be more evident if we trigger the weekly sell signal. Declines will likely be punctuated by short-term rallies that allow investors to rebalance portfolio allocations and reduce risk as needed. With the market approaching decently oversold levels, I expect a rally to start as soon as this week or next.
Revert To Your Process
If that happens, here is the process that we will follow.
Step 1) Clean Up Your Portfolio
- Tighten up stop-loss levels to current support levels for each position.
- Hedge portfolios against significant market declines.
- Take profits in positions that have been big winners.
- Sell laggards and losers.
- Raise cash and rebalance portfolios to target weightings.
The next step is to rebalance your portfolio to the allocation that will most likely weather a “cold snap.” In other words, consider what sectors and markets will improve in whatever economic environment you believe we will experience in 2025.
Step 2) Compare Your Portfolio Allocation To The Model Allocation.
- Determine areas requiring new or increased exposure.
- Calculate how many shares to purchase to fill allocation requirements.
- Determine cash requirements to make purchases.
- Re-examine portfolio to rebalance and raise sufficient cash for requirements.
- Determine entry price levels for each new position.
- Evaluate “stop-loss” levels for each position.
- Establish “sell/profit taking” levels for each position.
Step 3) Have positions ready to execute accordingly, given the proper market set-up. In this case, we are looking for positions that have either a “value” tilt or have pulled back to support and provide a lower-risk entry opportunity.
While market conditions remain uncertain, preparing and adjusting strategies can help investors navigate volatility confidently. As technical indicators flash warning signs, a well-structured risk management approach will protect capital and preserve long-term gains.
I hope this helps.
Tyler Durden
Tue, 04/01/2025 – 14:45
