This blog post originally appeared on RealMoney Silver on June 22 at 7:58 a.m. EDT.Summer has set in with its usual severity. Similar to many, I am trying to grapple with the market's outlook for the next few months. From my perch, the short-term market mosaic is particularly hard to decode. Indecision reins and is reflected in a relatively range-bound market, with the S&P 500 having been contained between 875 and 950 since early May and activity characterized by lackluster volume. In summary, I have concluded that a sideways correction or a deep correction are most likely, with a combined probability of 75%, and that a continued rally holds about a 25% probability.
Scenario No. 1: The Sideways Correction (Probability of 40%)I have previously suggested that a sideways correction remains the most likely market outcome this summer. As a metaphor, consider the market as a big bathtub with little new water (hedge fund and mutual fund inflows) being added into it. The bathtub market's water level remains stable, but the water swishes around from side to side as the bather moves. Industry rotation is the hallmark condition. The market, however, does not take a bath as, over the short term, extended sectors such as industrials, materials and energy will likely correct as more defensive sectors improve in their relative performance. A sideways correction would be intermediate-term healthy in the sense of correcting an overbought from the March lows and will likely presage a move higher in the autumn.
Scenario No. 2: The Deep Correction (Probability of 25%)Fundamentally, a continued weakness in retail spending could precipitate lost confidence and a deeper dive. So could weakness in business spending (as a byproduct of ever lower capacity utilization rates). Technically, a reversal in the Coppock Curve indicator -- it gave a technical buy at the end of May and is now in a sell mode -- and weakening Lowry's buying power augur for a plunge. It is important to recognize that a deep correction, similar the sideways correction, would also be healthy for the market's back-end-of-the-year market prospects.
Scenario No. 3: The Continued Rally (Probability of 35%)While giving the scenario only slightly better than a one-third chance, a new up leg is not out of the question. If the replenishment of depleted corporate inventories begins to occur in July, evidence of an impending production boom could be interpreted by market participants as a sustainable economic leg higher (an outcome with which I happen to disagree), which will carry expectations of improving corporate profits. With the appearance that the domestic economy is moving from "less worse" to "better," fixed-income yields would then rise. (The yield on the U.S. 10-year note could as high as 4.25% or 4.50%.) And, as I have emphasized, a large pension fund reallocation out of fixed income into equities could serve as a catalyst to energize stocks and take the averages through the upside of their recent trading range.
Looking beyond the near term, I would emphasize that I view the two correction scenarios as bolstering the market outlook during the fall-winter period. Both scenarios would serve to build up skepticism, shake up complacency and make it difficult for many investors to get back in. A sideways correction would frustrate the most and wear many investors out. A deep correction would again increase the fear of being "in" compared to the recent fear of being "out." A subsequent rally out of these two scenarios would be fueled by investors chasing strength as even in bear market rallies (1938-1939) there is typically more than one leg higher. By contrast, a continued rally would expose the markets to getting overbought once again and would likely serve to threaten equities in late fall/early winter.
Know what you own: Some active stocks in Monday's midday trading include Bank of America (BAC), Citigroup (C), the SPDRs (SPY), Direxion Daily Financial Bear 3X Shares (FAZ), Direxion Daily Financial Bull 3X Shares (FAS), PowerShares QQQ (QQQQ) and Financial Select Sector SPDR (XLF).