How deep can this stock market correction go?

Stock market sell-off gains momentum

If you ask the question, how deep can this go? stock market correction go, the real simple answer is all the way to the bottom. The correction is incredibly unlikely to cost the S&P 500 (NYSEARCA: SPY) to a valuation of $0, but it is highly likely that there will be a technical correction that could reach 20% or 25% from the last all-time high. More if the market corrects all the way back to what was a very significant secular uptrend line. Our point? There are a growing number of factors weighing on the market that can and will ultimately lead to a revaluation of the S&P500.

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The biggest risk to the S&P 500

The biggest headline in the news right now is Evergrande’s impending default, but that’s just one brick in the wall of worry facing the market today. Evergrande is a Chinese real estate developer with more than $300 billion in debt that may soon be in default. That is an absolute risk for China and could potentially create a knock-on effect by tacking into other economies.

Everything else is based on the Fed’s interest rate risk. The FOMC is hosting its policy meeting in September and is expected to bring an aggressive surprise to the market. The Fed is not expected to change its policy, but the trend in data supports the idea that the winding down should begin soon, if not already underway.

And inflation is a big risk for the market in more ways than one, as inflation underpins earnings growth prospects. The S&P 500 produce organic growth, but they also produce top- and bottom-line growth that is the direct result of price increases designed to fight inflation. At the moment, the companies’ balance has been able to offset the pace of their own rising costs and increase their margins, but that could change soon. Regardless, there are not a few companies that have reported significant effects on their bottom line due to higher input costs, wages and freight.

It’s also about the supply chain

The root causes of inflation, the root causes, are many, but include fuel and freight. Not only are fuel costs rising, but there is a cargo capacity shortage across the system that has been going on for years and showing no real signs of change. While the truck drivers and shipping companies have managed to attract new workers, the demand for capacity is greater than that and cost them dearly. Not only are shippers missing out, but they also have to pay higher wages and higher incentives and retention bonuses, adding to the already rising costs of shipping goods.

And then there is the supply chain angle of the freight issue. Not only is there a shortage of some essential supplies, including and perhaps especially semiconductors, but it is also difficult for companies to get what they need when they need it. This has an impact on revenue in the short term, but leads to greater backlogs which should support the activity in the longer term.

The bottom line is that the S&P 500 has a lot of headwinds in terms of revenue growth and earnings growth. The market has already been confronted with a dramatic delay in year-over-year growth due to the overlap of difficult compositions in the third quarter of last year’s calendar. If expectations and consensus estimates for third and fourth quarter growth begin to decline, the market could indeed make a very hard landing.

The technical outlook: the S&P 500 will fall at least 5%

The S&P 500 has already crossed more than -3% in this correction and it looks like it will easily reach -5% before gaining solid support. Recent price action is accelerating a move below the uptrend line and the short term moving average which is now pointing lower. The indicators are bearish and are converging with the decline, so we would expect price action to at least retest today’s low, if not at some point in the future.

Price action may stabilize over the next two days, but unless some urgently needed good news, we will see the sell-off fall further to at least the 4095 level. Longer term, we expect the index to move sideways and consolidate near the level of 4995 before the next big step is taken. If the earnings outlook continues to deteriorate, we could see the index complete a larger pattern and even change course. In this scenario, the index could fall into the long-term secular uptrend, down 36%.
How deep does this stock market correction go?

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