Why I Believe the S&P 500 Is Due to Drop at Least 150 Points

By Sasha Cekerevac

Many friends and readers have been asking me about the overall market and when we will see a market correction occur. For simplicity’s sake, let’s use the S&P 500 as a trading vehicle of choice to represent the overall market.

I believe we are close to a top in the S&P 500 and it could drop at least 150 points during the next market correction.

There are several reasons as to how I calculated the extent of the drop and how we are currently very close to the top. The first is that a market is a multiple of earnings—how much people are willing to pay for every dollar of earned income.

Historically, the average for the S&P 500 price-to-earnings (P/E) ratio has been about 15. A market correction occurs when there is a disconnect between the S&P 500 and the underlying fundamentals of the companies. Remember: the market leads the economy, which is exactly what has occurred over the past couple of years.

However, at this point, we are in a situation in which revenues are not growing, profit margins are close to all-time highs, and earnings appear to be stagnating. With the 12-month forward earnings per share for the S&P 500 estimated to be $117.00, this leaves the forward P/E ratio for the S&P 500 at 14.5. (Source: FactSet, August 2, 2013.)

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Is that outrageously expensive? No; however, it isn’t cheap. We need to look at where the risks and the potential rewards are to get a better idea of whether or not a market correction is likely.

In terms of rewards, the historic P/E ratio for the S&P 500 again averages around 15. So yes, we could see a slightly higher multiple for the S&P 500. But since earnings are stagnating and revenues are not growing, investors will become more hesitant to pay a premium in that type of environment. In this case, rewards seem limited.

The risks appear to be accumulating. As I have stated many times in these pages, I believe that once the Federal Reserve begins shifting its monetary policy by reducing its asset purchase program, we will see a significant market correction in the S&P 500. I’ve also expressed my opinion for months now that this will occur sometime this fall, most likely in September.

That is a significant risk to the S&P 500. I believe that a considerable portion of the move upward was based on investors’ expectations that the Federal Reserve would continue its current monetary policy stance. Once this sentiment changes, those investors will begin pulling out of the market, resulting in a market correction.

We will also once again begin hearing about the talks from Washington regarding the budget debt, raising the ceiling to keep the government working. Once Washington enters the playing field, it brings uncertainty. Investors hate uncertainty, which is yet another risk for a possible market correction.

In the chart of the S&P 500 above, notice that while the market has been hitting new highs, the moving average convergence divergence (MACD) has not been able to follow it. This is a negative divergence, indicating momentum is beginning to decline and a market correction may be near.

With risks beginning to increase, especially if the Federal Reserve were to begin reducing its asset purchase program, I believe a market correction could bring the S&P 500 down by about 150 points to approximately 1,550, which is the 50% retracement level of this current bull move. If the market fails to hold on at that level, a move down to 1,486, the 61.8% Fibonacci retracement level, would be my next target to watch.

This article Why I Believe the S&P 500 Is Due to Drop at Least 150 Points was originally published at Investment Contrarians