SP500 to Drop 14%
I am projecting the SP500 to drop 14% from the closing highs six weeks ago before finding a tradeable bottom. The week that QE3 was announced saw the SP500 close at 1465.77. By my calculations, the SP500 will bottom near the 1260 level, which is nearly 150 SP500 points from today's prices.
So how did I arrive at these numbers?
Figure 1 is a weekly chart of the SP500, and the indicator in the middle panel is the cyclical adjusted price earnings ratio (5 year). The indicator is wrapped in trading bands that looks for statistically significant extremes over the prior 52 weeks. The indicator in the lower panel is an analogue representation of our "dumb money" indicator that I show every Sunday in the weekly sentiment wrap up. With the indicator in the "up" position, investors are too bearish in their market outlook, and these typically are bull signals. What we know about investor sentiment is that it is cyclical. In other words, bearish sentiment will follow bullish sentiment and so on. Bullish sentiment peaked 6 weeks ago when QE3 was announced, and it has been rolling over with price ever since. If the present is like the past and if the cyclical nature of sentiment persists (and I have no reason to believe that it won't), then investors should turn bearish at some point in the future.
Figure 1. SP500/ weekly
But the question remains: at what point?
Now direct yourself to CAPE (5 year) indicator in the middle panel. In the overwhelmingly majority of the time in the past 22 years, the CAPE (5 year) will tag the lower trading band when investor sentiment turns bearish (i.e., bull signal). So going forward, my expectation is that investors will need to turn bearish on the markets (remember sentiment is cyclical) and this should coincide with the CAPE (5 year) tagging the lower trading band before prices bottom. What would it take to get prices to tag the lower trading band? The SP500 would need to drop about 150 points from its current level. This would put the SP500 at 1260.
Lastly, any downward price move that doesn't result in investor sentiment turning bearish will be pretty much the same. The ensuing bounce will be like the last 5 months, and it will be sub-optimal.