- Sven Henrich is warning stocks are due for a period of volatility ahead.
- The founder of NorthmanTrader.com said a 20% drop in stocks would be “healthy.”
- Other Wall Street luminaries also have dim outlooks with valuations and sentiment so extended.
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And rightfully so – both tend to be able to predict future market behavior, and both are relatively extended at the moment.
Henrich has identified a pattern in spikes in the CBOE Volatility Index, or the VIX, which typically goes in the opposite direction of the S&P 500. For example, when stocks started selling off in February 2020 ahead of pandemic lockdowns, the VIX jumped.
Using trendline wedges over the last four-year period, Henrich sees a burst in volatility looming as the wedge tightens – as has happened in each instance in recent years.
Other measures of volatility in areas of the market are showing similar trends, Henrich said. These areas include small caps stocks and tech stocks. The price action of each is shown on the top part of the following charts, while volatility is shown in the bottom section.
And tech stocks:
Henrich, who warned of extreme conditions before the 2020 crash, reckons the spike in volatility for the broader market could come this year or early in 2022, though timing it is difficult and it depends on a catalyst, he said.
“All this can take months to play out, but the message of all these patterns remains the same: a big volatility spike is coming and this ongoing one way market strength, ever so desperate to buy every single little dip, continues to disconnect markets ever further from historic trends,” Henrich said.
“If we’ve learned one thing over the past years it’s this: the extremes become ever more extreme, and when things are extremely stretched the reaction to the downside is often much greater than anyone can imagine,” he continued. “Nobody will give us a day and time as tops are processes, but the underlying picture keeps bubbling as it shows ever more weakening beneath the surface.”
One sign of “weakening beneath the surface” Henrich pointed to is the fact that the S&P 500 is pushing to new highs while breadth ($SPXA50R and $NYMO) and relative strength (RSI) are weakening.
Henrich didn’t explicitly lay out how far he thinks stocks are due to fall, but he did compare the similarity of the current situation to that of 1998, when stocks sold off by 20%. He said a 20% drop, which would put stocks into bear market territory, would be “healthy” and would present a buying opportunity.
Henrich’s views in context
With multiple market measures showing historic over-extension as indexes continually push upward, Henrich builds a compelling technical case that stocks are due for a reset.
A 20% drop in the S&P 500 isn’t far outside the realm of possibility, according to some on Wall Street. While some strategists still see upside, Bank of America’s Savita Subramanian and Stifel’s Barry Bannister – both the top US equity strategists at their respective banks – have end-of-year price targets of 3,800 for the S&P 500. From its current level around 4,350, that price target implies a correction of more than 12%.
The top US equity strategist at Goldman Sachs, David Kostin, also said in a recent note to clients that stocks could fall 18% if yields on 10-year Treasury notes quickly jump to 2.5%. They currently sit at 1.3%.
As inflation continues to surprise to the upside – it’s beaten economists’ expectations for three straight months now – bond investors could indeed start to demand higher yields. More attractive yields would mean greater competition for the stock market and could cause investors to exit stocks in favor risk-free assets.
Other threats to stocks are also present. The Delta variant of COVID-19 is spreading rapidly around the US and could trigger further lockdown measures. The Federal Reserve could also decide to taper its bond buying program earlier than expected, slowing its relentless stream of liquidity, if the economy overheats too quickly.
Of course, bears have looked silly so far this year. And bulls, with the support of the Fed, may continue to win out. But as indicators continue to higher extremes, a meaningful drop somewhere along the way should not come as a surprise to investors.