A couple of weeks ago, I wrote an article titled “Why the next 10% move in the stock market might be down.” The point of the article wasn’t to correctly predict the exact percentage move, but to signal that another leg down was likely coming in the market.

Since I wrote the article, the S&P 500 has dropped 10.2% in 11 days. To be honest, I knew the market was weak in early December but I really didn’t expect it to drop so quickly. Now that it’s happened, people are emailing me and asking “What’s next?”

The market is clearly in a correction. I really don’t care what term you want to call it (correction, bear market, cyclical bear within a secular bull). Who cares? Stop being an economist and just recognize that we’re in a downtrend. In downtrends, volatility is higher, technical breakouts don’t work, and strength gets sold into. The market usually trends higher all day (to sucker people in and give the illusion that it’s healthy) and then trends lower into the close (to show its true weakness).

Earnings are slowing down, and rate hikes on the horizon

Many people are asking why this is happening. The market moves because of two main factors: earnings and interest rates. While I don’t feel a recession is coming soon, earnings are definitely slowing down and the market is adjusting for that. Interest rates are still historically low, but the Federal Reserve is currently in a tightening cycle and you never want to fight the Fed. Before the Fed’s December meeting this week, many market participants were hoping they would only raise another quarter point and signal no more rate hikes in 2019. Instead, they signaled two more hikes next year (down from the expectation of three) and the market clearly did not like this. My feeling is the market and the economy can’t handle two more hikes and more deleveraging is to be expected.

Very few people are talking about the number of large hedge funds that are currently closing down. Part of the ugly selloff we saw in October 2018 was due to forced liquidation by many of these funds. My feeling is this will continue into the first quarter of 2019 and will keep pressure on the markets. In addition to hedge funds, equity mutual funds are seeing record outflows. According to @setimentrader, last week’s outflow of 0.44% of total equity fund assets was the largest in 15 years. The previous record was 0.39% in mid-August 2011.

Too many headwinds

The market never likes uncertainty and there are too many headwinds right now: China trade wars, the Fed tightening cycle, an earnings slowdown, fund outflows, the ECB bond buying program ending this month, and many other challenges. This is where one has to define themselves as a trader or investor. It’s important to know your time frame, risk tolerance, and overall investment objectives. I have held a large cash position for clients since early October 2018 because we closed below key averages, and many leading stocks were starting to break down. This strategy isn’t for everyone because it involves staying on top of the markets and the ability to make decisions.

If you are an investor with a longer-term view, you have to take the good with the bad and make sacrifices. This means riding uptrends longer than most people do, but also accepting these corrections along the way down. If you are a trader, I highly recommend saving your money for healthier conditions. If you are inclined to trade, there’s nothing wrong with using smaller than normal position sizes to help offset the market volatility and the wider price swings that can hurt many traders.

Of course no one knows where the market will go from here. All I know is to remain defensive until the big institutions come back into the market and start buying consistently. My worst-case scenario would be an eventual retest of the 2016 Presidential Election breakout, which would take us down to around 2200 on the S&P 500 (see chart).

Of course I don’t want this to happen, but I am open-minded to this possibility at some point in 2019. Hopefully, we get a resolution soon on many of the market headwinds listed above and the selling starts to slow down. Unfortunately, many of these challenges will likely take some time to resolve themselves. If I can leave you with a positive note, there will be tremendous opportunities when this correction is over and many stocks will explode to the upside. The key is to show some patience and discipline until then, and wait for the wind of the market to be at our backs.

I can be reached at: [email protected].

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