Wall St Is Due for a Correction

July 25th, 2016 by

As the immediate jitters over the Brexit vote in the U.K. began to subside as the calendar turned to July, the equities markets in the U.S. have been on fire.

Stocks keep on rising to successive all-time highs, but how long can this continue?

The simplest answer is that it can’t go on indefinitely.

Signs of Overheating

Given several troubling indicators, it appears that the time is nigh for Wall St to experience a pullback from its historic highs.

One of the most telling trends comes from the VIX, the volatility index. Typically, when volatility is relatively low for an extended period, it means that the current direction of the markets is losing steam. The steady upward climb would seem to imply that traders are becoming complacent in assuming stocks will simply continue higher. The VIX has fallen to a two-year low, an indication that a swing the opposite direction is becoming an increasing likelihood.

Image courtesy of Seeking Alpha

Another sign that a disproportionate amount of traders are bullish is shown in the put/call ratio. (Puts and calls are roughly equivalent to short and long positions, respectively.) As any seasoned contrarian investor will tell you, you generally want to be the opposite side of a bet when traders and investors are crowding into one side of a trade.

Moreover, technical analyst Tom McClellen’s “14-day Choppiness Index” has likewise shown an almost linear trend higher, the lowest volatility for a two-week period in about 20 years. His data goes all the way back to 1996.

McClellen explains, “Linear trends either upward or downward are very exhausting, requiring a lot of energy from either the bulls or the bears to keep everyone in formation and marching together. The market tends toward entropy [chaos], so excursions like this toward extreme organization cannot last for very long.”

Applying Common Sense

It’s worth considering the antithesis to this argument that Wall St is ripe for a downward correction. Our expectations about what is plausible or probable are often subject to an inherent bias. For instance, the chief market strategist at Convergex, Nicholas Colas, brings up what he calls the “Monte Carlo Fallacy”: when you have a 50-50 proposition (like flipping a coin, or a market moving up or down), the odds of each successive result are technically the same. Although we may raise an eyebrow at a coin coming up heads 10 times in a row, this is actually just as likely (or unlikely) as heads and tails alternating for 10 straight coin flips.

Nevertheless, Mark DeCambre for MarketWatch makes a convincing observation that the “wildly varying opinion on Wall Street about the viability of this recent run in stocks should serve as confirmation that few pundits or strategists, if any, know for sure where the market is headed.” During such uncertain times, your best bet is to protect your portfolio with an allocation of gold, the preferred safe haven from unexpected market losses.


The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.