Where’s the Downside Tipping Point for US Stocks?

Yesterday’s sharp slide in US equities has refocused minds on a hardy perennial: the market can and does go down. Obvious, of course, but easy to overlook when prices are rising virtually non-stop, as they have been for much of the past six months—until now.

The latest decline has grabbed the crowd’s attention for several reasons, including the fact that the selling comes at a time of new questions about inflation and Fed policy and the heightened risk of a widening Middle East conflict.

Deciding whether the market’s latest gyrations are noise or signal is the art/science of market analysis. There are no flawless techniques for divining the future, but there are several techniques to maintain perspective, which can be a foundation for making informed decisions on how and when to rebalance portfolios.

Let’s start by reminding ourselves that the current drawdown for the is still mild by historical standards. The market yesterday (Apr. 15) closed 3.7% below its previous peak – a drawdown that’s irrelevant in the grand scheme of market history for peak-to-trough declines.

What would constitute a possible early warning of deeper trouble ahead? There’s no magic number, but if the market slides further, and slips below a -5% drawdown, that would catch my attention.

Another way to try to separate the wheat from the chaff: monitoring how the S&P 500 trend profile evolves. A conventional approach is to watch the 50- and 200-moving averages. By that standard, we’re still a long way from a sell signal, at least for strategic-minded investors with medium-/long-term horizons.

Every bear market starts with a relatively soft, innocuous slide, however, and so there’s a case for keeping an eye on a shorter set of moving averages as a possible early warning sign. The hazard here is that shorter time frames suffer from a higher degree of noise and so extra caution is required. For the moment, there’s still no smoking gun, even for a shorter-term perspective. Notably, the S&P 500’s 20-day average is still comfortably above its 50- and 100-day counterparts.

Another way to minimize noise is to focus on weekly charts. As the next chart highlights, the trend remains firmly positive from this perspective, based on 10- and 40-week averages.

The analysis above barely scratches the surface of techniques for highlighting signals and minimizing noise, but it’s a reasonable way to begin. To refine the process further we can add in volatility and valuation profiles, and on those fronts the results skew toward adopting a more cautious risk posture. To summarize, market valuation is high, and recent volatility has been low – a combination that suggests the odds of a market correction are elevated vs. recent history.

Add in the recent rise in geopolitical risk via the still-evolving Israel-Iran conflict and it’s getting easier to rationalize the case for paring risk exposure.

Another dimension that helps determine how, or if, to change your risk positioning: the investment time frame. For short-term speculators, there’s a relatively strong(er) case for taking money off the table – less so, at least for now, for medium-/long-term investors.

The pushback to all of this is that a buy-and-hold strategy will win in the end. Point taken, and for some investors that’s the superior choice. But the assumption here is that you’re truly a buy-and-hold investor. Easy to say, hard to do, which is why risk management over shorter time frames is practical if not always optimal.