The Market Fell Through A Trapdoor. How Low Could It Go?
Key Takeaways:
Intro - The market dropped through an important support level last week and is below the 20, 50 and 200 day moving averages. It is in a confirmed downtrend. The S&P 500 actually started last week going up and then reversed down 5.39% from last week’s high to close near the lows. Technical analysts call this a bull trap and this implies lower prices are probably coming. The question is…how low could it go? I will use different methods to figure this one out.
The History Method - In this method I will just go over previous corrections and bear markets. If it happened before, it can happen again.
As you can see from the chart above, corrections and bear markets are a regular occurrence in the history of the stock market. The average drop is 37%, the Median is 30% and the Mode is 36%. The range is 15% to 87%. Taking out the smallest and largest outliers, we get a tighter range of 20% to 60%. I imposed these theoretical drop levels onto the S&P 500’s chart below. The February low of $4,115 (17.66x F P/E) is about a 15% drop. If the market dropped 20% it would go down to $3,843 (16.49x F P/E). If the market dropped 30% it would go down to $3,362 (14.43x F P/E). If the market dropped 37% it would go down to $3,029 (13x F P/E). If the market dropped 50% it would go down to $2,400 (10.3x F P/E). And finally if it dropped 60% it would go down to $1,919 (8.24 F P/E). Looking at the Forward P/E ratios, I don’t think a 50% or 60% drop is likely (but crazier things have happened) due to the TINA (There is no Alternative) environment. I believe a range of 20% to 37% in terms of drawdown size is reasonable. The 50% to 60% drop becomes possible if earnings falls hard.
The Monthly Moving Average Method - In this method I am using the monthly chart and setting the moving averages at lengths that correspond to important cycles. The moving averages I am using are the 48 month (4 Year Presidential Cycle), 84 month (7 Year Cycle), 120 month (10 Year Cycle), 240 month (20 Year Cycle) and 360 month (30 Year Cycle) simple moving averages (SMA). My fellow cycle analysts out there will probably recognize these as key cycles that W.D. Gann used. For those who don’t know W.D. Gann, he was a legendary trader who lived from 6/6/1878 to 6/18/1955 and had a large following. Looking at the charts below, you can see that bear markets and corrections have a way of stopping at one of these moving averages. The 2020 drop stopped at the 84 month SMA. The 2018 correction stopped at the 48 month SMA. The 2016 double bottom stopped at the 48 month SMA. The 2011 choppy whipsaw never broke the 240 month SMA. The 2008 Financial Crisis stopped at the 360 month SMA. The Tech Bubble Pop of 2000 stopped around the 120 month SMA.
Let’s go a little further back in time and you could see that this method holds up (see chart below). The 1990 correction held the 48 month SMA. The 1987 Black Monday drop also held the 48 month SMA. The 1982 correction held the 120 month SMA. The 1974 drop held the 360 month SMA. The 1970 drop held the 240 month SMA. The 1962 and 1966 corrections both held the 84 month SMA. The 1958 drop stopped at the 48 month SMA. And finally the 1953 drop held the 48 month SMA. Let’s see which moving average this next bear market will stop at (refer to chart above now). Using this method, the first stop is at the 48 month moving average of $3,436, which is a forward P/E ratio of 14.75x. The market may not get there, but I am holding an open mind. If it reached the 84 month SMA it would reach $2,940 (12.62x F P/E). I believe that these two levels are feasible based on the Forward PE ratios.
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The Darvas Method - Nicholas Darvas (1920-1977) was a cool cat. He was a Hungarian born economist who traveled the world to compete in dance competitions. On the side he made a fortune in the stock market and wrote the book “How I Made $2,000,000 in the Stock Market”, where he outlined the Darvas Method or the “Darvas Box Theory”. This method uses price action and volume to find levels of support and resistance that look like a box (or horizontal levels in my eyes). Using Darvas’s theories as a guideline, I could see the next levels of possible support are at $4,110 (17.6x Forward P/E ratio), $3,945 (16.9x F P/E), $3,721 (16x F P/E), $3,506 (15x F P/E), $3,393 or (14.56x F P/E), $3,200 (13.7x F P/E) and $2,957 (12.7x F P/E).
The Fibonacci Retracement Method - Understanding Fibonacci math could take the curious person down a rabbit hole that focuses on the growth of the universe! I’ll leave that conversation to the math brainiacs at CalTech and MIT. For active investors and traders, the Fibonacci Retracement technique has certain mathematical levels (displayed on the chart below) where a trend could retrace to before continuing that trend. I find this technique effective as the 2022 low so far has held the 23.6% fibonacci retracement level (although I don’t think it will continue to hold). The next level down is the 38.2% retracement level at $3,811 (16.36x F P/E). If that breaks, the next level is the 50% retracement level at $3,501 (15.03x F P/E). If that breaks, the next level down is the 61.8% retracement level at $3,191 (13.7x F P/E). And finally, if that breaks the next level down is the 78.6% retracement level at $2,751 (11.81x F P/E). Note that the $3,500 and $3,200 levels are both indicated by the Darvas Method and the Fibonacci Retracement Method and this could be a confluence level.
The Fibonacci Extension Method - This technique also uses Fibonacci math, but takes a different perspective. If a downtrend started in early January and the countertrend move from the February bottom to late March top was the retracement (which is now over), then how far can the next leg of the downtrend go? First let’s see if we hold the February low. If that breaks then the next extension level is the 138.2% extension at $3,914 (16.8x F P/E). If that breaks then the next level is the the 161.8% extension level at $3,790 (16.27% F P/E). If that breaks then the next extension level is the 227.2% extension at $3,447 (14.79x F P/E). If that breaks then the next extension level is the 261.8% extension at $3,265 (14x F P/E).
The Yearly Pivot Point Method - Yearly support pivot points are at $4,016 (17.2x F P/E), $3,974 (17x F P/E), $3,704 (15.9x F P/E) and $3,266 (14x F P/E). Yearly pivot points have proven quite powerful from my past experience.
Conclusion - Using these various methods, I see a few confluence zones (various methods point to similar levels). I believe that the confluence zones of support for the S&P 500 are at $3,950, $3,800, $3,500, $3,200, $3,000 and $2,950.
Throughout this article I’ve included the Forward P/E ratios at the key levels of support to hint at a concept — the current high valuation ratios are not palatable for informed investors and lower valuation levels are needed to attract buyers in force.
Note that all data used for this article comes from Stockcharts.com.