Bank of America flags three-wave S&P 500 correction that could drag global markets lower through September

Bank of America (BofA) issued a warning about the S&P 500 on June 26 that it is likely going to go through a major correction (drop in stock price) from July to September. The overall impact could affect other global stock and commodity markets as they are already in a weak position.

According to BofA’s Paul Ciana, Managing Director and Global Head of Technical Strategy, the outlook for the summer months shows a pattern of what is called an “abc correction” in which the index will move from one low point, back up to a high point, and then descend back down again in three distinct phases. If this play out as expected and follows through with a major drop to 6850, it would reflect a potential decrease of approximately seven percent from what the S&P has had recently.

BofA warns technical signals are turning bearish

The bank’s warning has three main points. The first is that momentum is going the opposite way as price. The S&P 500 has gone up by nearly 17% from the bottom point in March. The 14-day Relative Strength Index was at approximately 49 last Friday, significantly lower than the value on which the highest levels of the rally occurred, according to Business Insider. The second reason is that the June 1st TD Sequential “red 13” reading for exhaustion indicates that the current uptrend might be running out of fuel.

The third reason for the warning is that the past week’s decline to 7,334 on June 10th fits the pattern of a fourth wave in Elliott Wave Theory, which indicates that below the 7,334 level, there will most likely be a corrective phase. Although technicals were the basis of BofA’s warning and not macro forecasts, BofA gives reasoning that explains why even a small pullback will likely have a larger effect than average due to the current composition of the S&P 500.

This year, the S&P 500’s rise has again been driven primarily by a small number of large-cap technology companies and therefore the average price action of the market prior to the current rally has been heavily weighted to just a few companies, which has dramatically shifted the concentration of the market away from the S&P 500. This concentration effect will not guarantee that markets will see a correction; however, it will significantly increase the potential for bearish technicals. This could translate into sharper benchmark declines than during periods when market leadership is more broadly distributed.

“Be cautious if a marginal new high toward ~7,741 occurs as it may be a ‘bull trap’ consistent with an expanding flat,” Ciana said in the client note, according to InvestmentNews.

Tech-heavy leadership increases correction risk

The warning from BofA is coming at a delicate time for international markets. According to InvestmentNews, the S&P 500 has gained 8.6% year to date; however, it has lost 1.9% over the last month.

The tech-laden Nasdaq has declined even more than the S&P, with almost a 5% decline during that same period. The hardest-hit sector has been semiconductors and memory chip stocks. Examples: last week, Broadcom fell 10%; Nvidia was down by 8%; Intel lost 7%, according to Business Insider.

There is also growing geopolitical tension, heightening valuation concerns with respect to future corporate earnings and economic activity. While there has been some lessening of pressure due to the U.S.-Iran conflict, it continues to be an ongoing source of concern.

In addition, the pressures of high oil prices at the beginning of this year have produced enough inflation to cause the Federal Reserve to leave rates unchanged during their recent board meeting under the new chairman Kevin Warsh, as per InvestmentNews.

While it is important to understand that BofA’s caution does not equal a recession forecast; rather, it identifies negative technical momentum in the market and deteriorating technical conditions, rather than creating a negative corporate earnings or economic activity forecast.

This is an important point distinguishing BofA’s outlook relative to prior events of technical corrections, since they have occurred frequently in the past during periods where there has been continuing economic growth in the past.

Whether the anticipated pullback gets reestablished as a temporary consolidation or an extended downtrend will be based on whether or not the upcoming earnings announcements and key economic data will provide validation – or detriment – to the current technical weakness of the markets.

David Laut, the Chief Investment Officer at Kerux Financial, commented to InvestmentNews that what occurred in the market in June was just the “tip of the iceberg.” He could foresee a broader market correction (10%-20%) due to high valuations, geopolitical uncertainty, and thin summer trading volume. Laut suggested that since August is only one month away. It is “a seasonally weak month for stocks and is a month that has seen corrections in past years”.

Global markets could feel the S&P 500 pullback

Not only U.S. portfolio holders will be adversely affected by a prolonged pullback in U.S. equity prices. The S&P 500 is the benchmark for trillions in passive funds globally, and a prolonged period of trendline corrective activity will almost certainly cause increased financial strain on global capital markets that rely heavily on U.S. risk sentiment, including those in London and Tokyo.

Because S&P 500 companies provide the backbone for the many exchange-traded funds or ETFs, pension funds, and institutional investment strategies that rely on tracked U.S. equities, a technical sell-off, due to an established trend of need to execute portfolio rebalances, may force investors to re-evaluate their risk profile and allocate funds towards alternative equity types versus their existing U.S. based equity holdings.

Historically, these changes have tended to migrate into non-U.S. equities, non-investment grade corporate credit markets and commodities, particularly during the Northern Hemisphere summer months when trading volume is typically lower than in other seasons and price movements are generally much larger than normal.

Laut recommended that investors maintain a negative weighting in technology stocks. He stated that the group of stocks currently known as the “Mag 7” have had disappointing performance to date, and the market is still attempting to determine which group will take the lead going forward. He strongly suggested diversifying into small cap, international and value stocks, as they have overall outperformed the overall technology group relative to their benchmark, according to InvestmentNews.

Ciana’s research team does not believe the bull market phase of the U.S. equity market will end during the third quarter or continue to have a strong year-end statistical performance, according to a report from Business Insider.

Nevertheless, there exists a risk of volatility resulting from a prolonged correction into the fall and potential double top from price consolidation occurring over the next several months, according to InvestmentNews.

As the result of consensus among the BofA analysts, investors are encouraged to consider the likelihood of a three-wave decline becoming less indicative of an overall bearish market call and more representative of a more extreme divergence between price momentum and the amount of capital flowing into the market.

If the second quarter earnings and the communications from the Federal Reserve continue to support economic growth, and the decline in capital flows during Q2 is part of the normal consolidation phase before continuing in the bullish trend, then the current market consolidation may turn out to be a generally healthy and continuing component of the larger bull market.

If, however, the trend of downward price momentum is accompanied by weaker-than-expected earnings releases, or indications from the Federal Reserve of increasing inflationary tensions, then the current pullback in the U.S. equity markets may continue to exhibit downward traction, as well as to continue to put downward pressure on global equities, as compared to a pullback of similar magnitude would otherwise indicate.

Keep an eye on the speech by Fed Chair Warsh at the ECB Forum in Sintra, Portugal, on Wednesday. Any comments he makes regarding the Fed’s projected interest rate policy will help determine how deep and how long the current period of market correction will be.

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