Four reasons a stock market correction is likely

Not many market participants expected such a start of the year: the S&P 500 Index (SPX) declined by more than 3% in January. Many stocks are still holding up well. However, more and more warning signs have been showing up and there is the possibility of a major correction in the making.

Let’s review the bearish arguments:

Major breadth divergence: I have been writing about breadth divergences for months: fewer stocks have been participating in the rally since last summer. Weakening breadth has always preceded major declines in the past.

There are various ways to measure market breadth: popular indicators are the number of NYSE stocks recording 52-week highs or the number of S&P 500 stocks trading above their 50-day moving average. Both measures have been declining while indices rallied higher.

Weak consumer discretionary stocks: When leading sectors start to break down, watch out. On one hand, simple sector rotation could be in place, but on the other side the development could just be the “canary in the coal mine.”

The sector to watch here is consumer discretionary stocks, which had outperformed the broader market since the end of the Financial Crisis in 2009. This trend was broken this January: The Select Sector SPDR Consumer Discretionary ETF (XLY) has declined more than 5% since the start of the year.

Emerging markets catalyst: In 2011, Europe was in the middle of its sovereign debt crisis. European equity markets were not only the weakest performer, but also pulled down stock worldwide. Will emerging markets be the 2014 catalyst to trigger a worldwide correction?

Some countries are already down significantly: The iShares MSCI Turkey ETF (TUR) has lost almost 50% of its value since last summer and is down over 6% in January alone. Emerging markets are struggling with a changing interest rate environment.

Some countries are extremely sensitive because foreign investors have started to bring their money back to the US, where yields are expected to rise. The technical pictures for these markets, such as Brazil, Turkey or China are not positive.

No fear: Even after the decline in January, investors do not seem to be fearful. One of the indicators I’m looking at is the ratio of traded equity put and call options. As of the beginning of February, the ratio averaged 0.55 over the last 10 days, which a very low reading. This means that almost twice as many call than put options were traded and indicates a high level of complacency.

When investors are in bearish mood, the number of put options traded can be equal to the number of call options. Low fear levels mean higher potential for lower prices.

Overall, buyers who bought on dips were rewarded in 2013 and every minor decline was bought. At one point, however, the music will stop playing and dip buying will stop working. Chances are, we’ll see a significant correction soon.

In my opinion, however, even a decline to 1,550 in the S&P 500, which would represent a 12% correction from current levels. That would not destroy the long-term uptrend in US equities from a technical standpoint.

DISCLAIMER: The investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.