Luke Lango Issues Dire Warning

A $15.7 trillion tech melt could be triggered as soon as June 14th… Now is the time to prepare.

Tue, June 6 at 7:00PM ET

Reality Check: This Is Where the S&P 500 SHOULD Find Its Floor

Ouch. An 8% decline over the course of three consecutive trading days may be a modern-era record for the S&P 500 and the Dow Jones Industrial Average. Record or not, though, the last three trading days (including Monday) have certainly been a painful reminder that stocks can and do take big hits.

Reality Check: This Is Where the S&P 500 SHOULD Find Its FloorIndeed, the last time we’ve seen a correction (from peak to trough) bigger the 10% dip we’ve seen from the S&P 500 since May was in mid-2012. We saw a bigger one in mid-2011, of 26%, which was spurred by fears surrounding Europe’s debt crisis. In mid-2010, the so-called “Flash Crash” was the centerpiece of a 20% correction from the S&P 500.

But, we managed to go 166 consecutive weeks — which was a modern-era record — since suffering a correction of 10% or more.

Maybe we’re just making up for lost time.

Whatever the case, there are two things investors of all ilks need to know about this pullback: Despite the headlines, the global economy isn’t careening off of a cliff, and China is just an excuse for traders take some profits on overvalued stocks, just like they’ve been itching to do for a while.

It’s not a lot of fun, but it’s creating an enormous buying opportunity. The trick is just figuring out where the bottom will be (and even that isn’t terribly important).

The Secret Truth of China, the Stock Market and Life

The notion that the rise and fall of the Shanghai Composite Index isn’t somehow a symptom of what’s causing a ripple effect across world markets isn’t going to sit well with most investors. That’s because the media loves to (has to?) play the cause and effect game, suggesting everything that happens in the U.S. can only be happening because something else either here or abroad has made it happen.

The truth is, however, not so simple.

Despite all our efforts to get a firm grip on how and why the market does what it does, the stock market is far more random and unpredictable than most care to admit. Sometimes, the reason stocks rise or fall isn’t quantifiable, or even clearly subjective. Sometimes, it just happens because it’s time for a change.

That being said, one of the reasons the market is so unpredictable is that when it’s all said and done, people are driving it higher and lower based on — and this should come as a surprise to nobody — fear and greed. Problem is, fear or greed can cause us to make not-so-hot decisions, and in many cases, one immediately follows the other.

So why the life lesson in the midst of an up-close-and-personal look at the meltdown of the S&P 500, the Shanghai Composite, and the rest of the world’s market indices? Simple … to make the point that this implosion isn’t rooted in some recognition that the global economic engine is on the verge of stopping.

Rather, if anything specific, it’s the sudden realization that stocks’ valuations — past, present, and future price-to-earnings ratios — didn’t make sense. It’s possible (maybe even likely) the world’s investors don’t even realize they collectively came to this conclusion on a subconscious level.

It’s a point we have to make first to make the follow-up point — once traders realize the psychological pendulum has swung too bearish too soon, that same pendulum will start swinging back the other way.

Likely Downside Targets for the S&P 500

While the global economy is still growing, and earnings (save the energy sector) are still on the rise, stocks remain overvalued even after the recent meltdown. Although big selloffs in stocks like Apple (AAPL) or Facebook (FB) invite big bounces, charts of the S&P 500 and the Dow Jones have developed plenty of bearish momentum and now the selloff must play out.

S&P 500 Valuation ScenariosThe question is, where is the bleeding most likely to stop?

There are two models to figure out where the most likely landing spot is. One is based on fundamentals, and the other is based on technicals. While most consider it gauche to mix the two, the fact is, the two schools of thought tend to work together better than most care to admit.

The fundamental-based model is simple enough: What’s the “correct” P/E for the S&P 500? Based on trailing and projected earnings, if the market’s long-term average P/E of 15 is the right figure, then arguably the S&P 500 should find 1,630 sooner than later. Yikes.

That said, that long-term average P/E incorporates some really high valuations that are generally seen in recessions. While we’re not in a recession yet, we may want to be a little more generous and up our tolerance to a more palatable P/E in the mid-16s. That implies a value of somewhere in the mid-1,700s.

That’s still pretty ugly.

Fortunately, the forward-looking P/E scenarios are looking a little more generous, so from a valuation standpoint, the low-to-mid-1,800s may be enough to make stocks palatable again.

Still, we’re talking about another 3% to 4% decline from where the S&P 500 is right now. Ugh.

The thing is, now that the S&P 500 and other indices have broken under any last bastion of support, we’re in a proverbial no man’s land in terms of technical analysis, with no nearby context for where support may be found.

In situations where there’s no nearby technical context to use as a trading framework, the application of long-term Fibonacci lines comes in handy.

In this case, assuming the last big pullback from mid-2012 is the starting point and the 166-week correction-free run is the most important span in question, the 38.2% Fibonacci retracement line implies the most logical floor is around 1,726.

As a reminder, however, a trip to the lower 1,700s would merely pull the S&P 500 back to its long-term valuation, as measured by the P/E ratio.

S&P 500, Fibonacci Lines

Though not quite as pertinent, we have to respect the possibility that last October’s low around 1,815 could already be a major psychological line in the sand.

Oh, and it’s no coincidence that the two most plausible technical floors pretty much line up with both of the most plausible fundamental and valuation scenarios.

Bottom Line

For the bulls who can see past all the smoke of today’s and last week’s steep selloff, it’s tempting to start wading back into stocks. In fact, Monday’s intraday action already vaguely hints that a bottom has been made. Maybe it has.

On the other hand, considering we’ve gone more than three years without a correction of more than 10% from the S&P 500, it’s entirely possible there’s still plenty more froth to burn off. Now that the bearish ball is rolling, the masses may decide this is the ideal time to go ahead and take all of our lumps and set up the usual fourth-quarter rebound rally. If that’s the case, any rebound effort from here is apt to be a short-lived one.

However it all plays out though, make no mistake: None of this truly appears to be the end of the bull market, nor the beginning of a recession. Europe’s sovereign debt crisis in 2012 didn’t kill the economy. Japan’s debilitating tsunami and destruction of a nuclear power plant in 2011 didn’t kill the stock market.

The government shutdown and threat of a credit downgrade of the United States government in 2013 didn’t have any long-lasting effect on stocks or the economy. Global markets will survive the selloff of the Shanghai Composite, which was never anything more than government-induced paper gains anyway.

Point being, while others are hysterical, savvy investors are already going bargain shopping, buying on this dip and (wisely) not becoming too consumed with pinpointing the exact bottom.

As Baron Rothschild put it, “The time to buy is when there’s blood in the streets.”

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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