Watch Out For The August Stock Market Correction

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These are not normal times. US stocks are now more overbought than any time in their history.

Price earnings multiples at 20X in a 2%-a-year-growth economy are unheard of. The geopolitical backdrop is worsening, with black swans arriving weekly.

And Brexit? Has anyone heard of Brexit?

Usually, this would be enough to cause me to don my helmet and hide out in a deep bombproof desert bunker with a year’s supply of food, water and ammo.

But it gets worse.

The frenetic rally in stocks we have seen since the post-Brexit low six weeks ago, has been of the lowest quality I have ever seen.

It has occurred with steadily falling volume. There has been almost no individual or institutional participation.

It has been all about companies buying back their own stock, and hedge funds covering losing shorts on stop-loss orders.

Here is the great irony in what is going on in all asset classes globally.

Central banks are flooding the world with money in order to stimulate economic growth. This was partly spurred by the surprise Brexit. But the rot was already well advanced everywhere.

This has driven interest rates to absurdly low levels. Eventually, this will stimulate economies, as it successfully did in the US from 2009 to 2014.

However, the immediate impact will be to drive up the price of ALL financial assets.

This is why you have seen the unheard of occurrence of simultaneous highs in stocks (NYSEARCA:SPY), bonds (NYSEARCA:TLT), precious metals (NYSEARCA:GLD), REITs (NYSE:GGP), Master Limited Partnerships (NYSEARCA:AMLP), and the US dollar (NYSEARCA:UUP).

I know this is supposed to be impossible according to your economic textbooks. But it is happening.

For the mathematicians out there, let me tell you how insane things have gotten in the stock market.

With the Dow Average up NINE CONSECUTIVE DAYS mid-month, we approached a three standard deviation move in prices.

Usually, you only see moves of this magnitude in sudden gaps DOWN.

You saw this in the two day, 1000 point drop that followed Brexit, the 10% melt down in January triggered by weak Chinese economic data, and the August 2015 1,100 point flash crash.

To see three standard deviations on a move UP is a once in a lifetime event. The last time I saw one was in 1989 at the end of the great Japanese bull market.

But wait! There’s more!

The S&P 500 is now 7.67% above its 50-day moving average, an occurrence as scarce as hens’ teeth. You almost have to be as old as me to remember how often this happens.

The narrowness of this rally is almost unprecedented. My technical friends have been jumping up and down screaming that only 28 of the S&P 500 are at all-time highs, and a mere 78 are in clear uptrends.

To see so much buying focused on so few shares is unnerving, to say the least.

All of the above is why I have sold short the S&P 500.

Mind you, this is not the time to bet the ranch. I have put on a position that is as conservative as possible, namely the August $221-$224 vertical bull put spread.

I have gone front month, deep in the money, and small in size. The (SPY) has to rise another 1.8% on top of an already incredible 9.60% move for me to lose money on this position. And it has to accomplish this feat in a short 17 days.

If the stock market continues to appreciate, I’ll just roll the position up and double the size.

Here are two downside levels that are key to any retracement:

$2,135 – is the previous high for the S&P 500 that certainly bears retesting. If it holds, we are going to even higher highs. If it doesn’t, new allocations to equities are put on hold.

$2,080 – Is the next level of support. If it holds, we will set up a new trading range from $2,080 to $2,170 for the foreseeable future. If this one fails, the market will give back its entire July rally and take us back to the Brexit low of $1,980.

In either of these cases the existing short position earns the maximum potential profit of 18.2%. It’s better than a poke in the eye with a sharp stick.

Anyone who is aware of the above might want to join me in my desert bunker.

If you send me a nice email, I’ll save you a place. Just bring your own M-16.

Man Being Gored by Bull

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.