How to Tell If a Stock Market Correction Will Happen

This morning’s financial news is dominated by two stories. Combined, they make it look likely that one way or another a correction in the market, technically defined as a decline of ten percent or more in the major indices, is coming. First, the Delta variant of Covid-19 is all over the news, raising fears of a return to restrictions that will negatively impact the economy, including stock prices. Then there is this story on CNBC, that “There’s growing support within the Fed to announce the tapering of bond purchases in September,” and we all remember the kind of tantrum the market can throw when tapering begins.

So, if both are taken together, we will either see a correction because growth will collapse as Delta surges, or a correction because one of the important factors driving that growth, easy monetary policy, will be ending precisely because growth didn’t collapse as Delta surges. It is a classic dammed if you do, dammed if you don’t scenario. Therefore, we know the probable outcome, and the important questions for investors are: when will the drop come, and how will we know when it arrives?

Usually the first question — when it will happen — is impossible to answer. This time may just be an exception to that rule. This morning’s story about the rumblings at the Fed is quite specific. They are talking about making an announcement following the next end-of-quarter FOMC meeting in September, with the actual tapering coming as soon as October. The market is a bit lower after that story broke this morning but won’t really react until any policy change becomes official, or is embraced by Fed Chair Jerome Powell, and we know when that will be.

The data releases for August will give an idea of the impact of Delta, and they will begin with the Jobs report print on the third of the month. PPI and CPI will be announced about a week later, then the Fed is scheduled to meet September 21 and 22, at which time they will factor those data into their decisions. So, in theory, by September 22 we will know if the Fed will taper.

The thing is, if I can see that, then so can every trader and investor.

There is no secret here, which means the bigger danger is that we initially grind lower in anticipation of the data and decision then see a rapid acceleration in the drop as we get closer to the beginning of September. There is, however, a technical signal that traders and investors can watch that will give an indication when either that acceleration will come, or at what point stocks will arrest the slow decline and wait for the Fed decision: the S&P 500’s 50-Day Moving Average (MA).

As you can see, the 50 MA has been a solid and consistent support this year. We have touched it, or have come close to touching it, eight times, but on no occasion has the index closed below the line for two consecutive trading days. If it does in the coming weeks, it will prompt an acceleration of the selling. When a technical signal is that obvious and well defined, it becomes a self-fulfilling prophecy. It is clearly a significant support, so a break of it will signal a move lower, which will prompt the selling that will cause a move lower.

The beauty of using the 50 MA as your signal of trouble ahead is that it is not too far away. A break of it at this point would imply a decline of around three percent, and if that comes, trimming positions and using it as an excuse to sell off some losers and take some profits, and also buying something like VXX or SPXS would make sense. If that 50-day moving average support holds, however, hold off on any selling. It could be that Delta will slow the economy just enough to stop it overheating, and to allow the Fed to reduce asset purchases at a pace that won’t cause a major disruption. If that is the case, we will continue on ever higher.

So, as much as a correction looks almost inevitable in the light of the two main news stories this morning, you should wait before selling in anticipation of it. There is a chance it won’t happen, and with a major support just three percent away from current levels, it makes sense to use that as your signal that a full-on correction of ten percent or more is coming.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.