Investment Contrarians

Warning Signs of a Market Correction for S&P 500

By for Investment Contrarians |

Warning Signs of a Market CorrectionOver the past few months, the strong performance by the broader market, best represented by the S&P 500, has been far better than most analysts and investors had expected.

Considering the political situation in America, especially with the fiscal cliff talks, and the questions surrounding earnings, the S&P 500 has risen to levels not seen in years.

However, there are some indications that perhaps a market correction in the S&P 500 is likely. One indicator is to use insider selling information to gauge how corporate executives view their companies.

For the week ended February 1, 2013, the Vickers Weekly Insider Report, produced by Argus Research, reported that the insider sales ratio was nine to one for stocks on the New York Stock Exchange (NYSE). This means that for every one share bought by insiders, they sold nine shares. (Source: Hulbert, M., “Insiders now aggressively bearish,” MarketWatch, February 6, 2013.)

This is an extremely high level of insider selling. The last time the ratio was this high was in the summer of 2011, just prior to a market correction in the S&P 500.

Note that this does not guarantee that a market correction in the S&P 500 will occur. There have been many times in the past when insider-selling pressure was high and the market continued moving higher. However, based on information gathered by Argus Research, when the insider selling ratio gets to this point, the Wilshire 5000 index experiences a market correction of 2.1% over the next month.

While many analysts had expected a disappointing earnings season to cause a market correction in the S&P 500, so far, companies have performed quite well.

Of the 500 firms within the S&P 500, 234 have reported earnings for the fourth quarter; approximately 70% reported earnings higher than estimated, with average growth of four percent. This compares to a decrease in earnings by one percent for S&P 500 companies during the third quarter. In addition, 67% of S&P 500 companies reporting stated that sales for the fourth quarter were above estimates, an increase from the average of 50% of firms exceeding revenue estimates over the prior four quarters. (Source: “S&P 500 companies continue to beat EPS and revenue estimates at earnings season midpoint,” FactSet, February 4, 2013.)

With both revenues and earnings beating expectations, this certainly cannot be a catalyst for a market correction in the S&P 500. Identifying an exogenous catalyst that is unknown is clearly impossible. Insider selling is worrisome to the extent that corporate executives know far more about the companies than anyone else.

Perhaps insiders believe that this earnings season, in which companies are exceeding revenue and earnings guidance, is a temporary, one-quarter improvement, with the possibility of a market correction in the S&P 500 coming later this year.

S&P 500 Large Cap Index Chart

Chart courtesy of www.StockCharts.com

This is a monthly chart of the S&P 500 since 1997. The S&P 500 is about to hit a huge resistance level in the area of 1,550–1,560. This coincides with the market peaks of 2000 and 2007. Following each previous attainment of this level, the S&P 500 suffered a serious market correction.

The one main difference is that the latest upward move since the bottom in 2009 for the S&P 500 has not created any overbought conditions in the relative strength index (RSI). An overbought condition in the RSI for the S&P 500 would occur when the upward move occurs at a faster rate than is possible to maintain over a long period of time.

There is the possibility that the S&P 500 will start to accelerate through this resistance area, creating a blow-off top before a market correction occurs. Or, the S&P 500 could experience a small market correction, perhaps similar to the previous corrections when insider selling was high at two to three percent; it could then build momentum once again and move significantly higher.

At this point, while the S&P 500 is due for a market correction, the bull market is clearly intact. We will only know if the market correction will be small or large once the S&P 500 hits this resistance area and encounters a higher level of selling pressure.

Many investors who have bought shares in the S&P 500 over the past few years are sitting on massive profits and will certainly look to cash out at some point. We cannot look for a disappointing financial reporting season, since so far, companies have exceeded on both earnings and revenues.

What will most likely trigger a market correction in the S&P 500 is an external catalyst that isn’t obvious at this point. You could argue that the high of the year for the S&P 500 could be made in this resistance area, creating a huge triple top and leading to a market correction. I would certainly look to take some profits off of the table ahead of this big resistance level.

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