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The S&P 500 Can Rally 25% - But May Need to Go Lower First

The good news? We will see new highs again and the S&P 500 will undergo a significant rally. The bad news? We don't know it will happen or how low it will go first.

The velocity of this decline has been unprecedented. Only seconds into Monday’s trading session and we had "limit down" for the third time this month as the S&P 500 fell more than 7% at the open.

Should a 13% decline occur on Monday, another 15-minute halt will take effect. Down 20% and the market will close for the day. The hope is we will not see either halt play out, particularly the latter of the two.

It’s got investors wondering what’s next for stocks and asking whether they can rise again?

There’s an old saying on Wall Street that investors should not fight the Fed. On Sunday evening, the Federal Reserve launched another round of quantitative easing to go alongside a rate cut to zero. It’s being done in a coordinated effort with central banks from around the world.

That’s not something I want to fight, but as we’re seeing on Monday morning it’s not helping the markets much. At least not yet. The concern here is a freezing of the financial system and whether it can absorb such an intense shock as the flow of cash and credit dries up. The Fed is trying to soften that blow, keeping the flow of credit as open as possible.

If investors start to see a flattening of growth for coronavirus cases and believe that this is a short-term shock rather than a long-term financial epidemic - the old question of illiquid vs. insolvent - then we can start to see a turn in the market.

Can the S&P 500 Rally 25% From Here?

Weekly chart of the S&P 500

Weekly chart of the S&P 500

To be clear, this is not a bottom call. The low could be in on Monday and retested in two months. The low could come many points lower than current levels at an unknown time in the future. There is simply no way of knowing with any certainty.

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However, I do believe this is a situation of illiquid vs. insolvent, and I do believe it’s the former rather than the latter. The U.S. and the world are taking extreme measures to limit the impact of Covid-19, while the Fed is taking extreme measures to ensure liquidity. Doing so now may be painful - economically - but it will hopefully put us in a better position 30, 60, 90, 180 and 365 days later.

At some point, stocks will go higher because this isn’t the end of the world. Look for when the market no longer falls on bad news or when it, as doubtful as it seems now, begins to rally on bad news. 

Should equities rally 25% from Monday’s low, that will send the S&P 500 back the 2019 breakout level near 3,000. For equity investors using the SPDR S&P 500 ETF  (SPY) , that level comes into play around the $300 mark.

Should the S&P 500 get back near the all-time highs around 3,400, that will represent a rally of more than 41% from Monday’s low.

Of course, the big question is where the bottom is at. As an optimist, I eventually expect higher prices down the road. However, I’m also a realist, and with the Volatility Index undefined north of $70 and a spreading virus shutting down most of the world, we have to be open to lower prices.

The first lower support level comes into play at 2,346, the low from 2018. That peak-to-trough decline of 20.2% over 65 trading sessions feels mellow compared to the 29.2% decline we’ve seen in just 18 sessions thus far.

In any regard, should we lose the 2018 low, it puts the 2016 fourth-quarter breakout - the so-called “Trump rally” - near 2,200 in play. Should we hit that point, it will represent a decline of more than 35%.

Let’s hope we find our footing sooner rather than later. Once we do, the stock market will begin to move higher. Like the decline, the velocity of ascent is unknown, but a rally will eventually come. As TheStreet’s Jim Cramer says, no one ever made a dime panicking.

Do not disregard risk, but know that brighter days will come.