Has the Stock Market Correction Already Begun?

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For months I’ve been asking if the red-hot stock market has gotten too far ahead of itself. Between December 31, 2012 and May 22, 2013, the S&P 500 increased 19%. During the same period, the Dow Jones Industrial Average climbed 18.9%.

These strong increases came in spite of the fact that during the first quarter of 2013, 78% of the S&P 500 companies issued negative earnings-per-share (EPS) guidance and nearly 80% of the S&P 500 companies issued a negative outlook for the second quarter.

I argued that the current bull market has nothing to do with the shape of the U.S. economy. The current bull market has been supported by the Federal Reserve’s $85.0-billion monthly quantitative easing policy and artificially low interest rates.

And once the quantitative easing policy is cut back, Wall Street will no longer be able to rely on the Federal Reserve, and instead will have to focus its attention on the shape of the actual U.S. economy.

It’s quite possible that investors are beginning to see how dire the U.S. economy actually is. On May 22, the Federal Reserve hinted it might start tapering off its $85.0-billion-per-month quantitative easing policy as early as Labor Day. The markets haven’t been the same since.

Currently trading near 1,600, the S&P 500 is trading down more than four percent from the peak of the rally on May 22. It has also been making lower lows, consistent with a textbook downtrend. The Dow Jones is in hot pursuit, trailing almost four percent from its May 22 peak. The longest uninterrupted rally since the markets bottomed in early 2009 is in jeopardy.

And so is the misplaced and unfounded optimism by investors. Before the Federal Reserve hinted on May 22 that it might start tapering off its quantitative easing policy (currently set at $85.0 billion per month), 50% of American investors said they were bullish on the economy, while only 20% were bearish. This is a total reversal in sentiment from just a month earlier, when just 19% said they were bullish and 54.5% were bearish. (Source: “Sentiment Survey Past Results,” American Association of Individual Investors web site, last accessed June 7, 2013.)

History is repeating itself. Immediately after the Fed’s May 22 comments, American investors began pulling on the reins. Today, only 29% are bullish, while 39% are bearish, and fewer people are feeling neutral about the U.S. economy.

So, has the stock market gotten too far ahead of the economy? It certainly seems as though domestic and global economic indicators have less to do with the bull run than they ought to. U.S. first-quarter gross domestic product (GDP) growth came in well below the expected expansion rate, U.S. unemployment is high, and wages have actually crashed.

Where should investors look in an uncertain market? If a stock is undervalued, you buy it; if it’s overvalued, you short it. The same principle can be used for the entire stock market.

If you think it’s undervalued, look into exchange-traded funds (ETFs) that are heavily weighted toward either the Dow Jones or S&P 500. If, however, you think the markets are overvalued and due for a correction, you can consider any number of ETFs that short the Dow Jones and S&P 500.

While a volatile market may not be the best climate in which to adjust your retirement portfolio, it’s important to ensure it is optimized to help you reach your long-term investing goals. When it comes to Wall Street, history always repeats itself—the markets are cyclical and, judging by the current bull market, they never fail to recover.

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