S&P 500 Rally Starting to Look Overstretched: How to Play a Possible Correction

The S&P 500 has hit four new all-time highs in as many days. Wednesday’s rally ran into a bit of trouble late in the day, which saw the major indexes give back all or most of their earlier gains.

Index futures have been stable so far, despite Tesla's (NASDAQ:TSLA) underwhelming earnings that took some shine off the tech euphoria.

The electric carmaker warned of “notably lower” sales growth before the launch of the new model next year.

Investors will be eyeing the ECB rate decision, as well as a slew of US data that includes GDP ahead of next week’s Fed meeting.

The key question is whether Wednesday marked at least a temporary top in this current phase of the rally, or do we just continue plowing ahead despite concerns over valuations, the Red Sea (NYSE:SE) situation, and the delay in interest rate cuts?

Tesla aside, we had seen some good earnings, especially Netflix (NASDAQ:NFLX), while the Composite PMI of the manufacturing and services sector rose to its highest level since June.

This added to a string of forecast-beating data we have seen lately.

Among other US data releases that have beaten expectations lately include retail sales and jobless claims falling to their lowest level in more than a year.

The UoM’s consumer confidence survey rose sharply to 78.8 from 69.7. On top of this, China’s latest efforts to shore up its struggling equity markets also boosted investor confidence.

S&P 500: Rally about to run into resistance at these levels?

Following the dovish rate-cut euphoria that propelled stocks to record highs in the last month of 2023, you would have thought the start of 2024 might see the markets stage a bit of a correction.

Expectations over the Fed’s rate cuts have been pushed back.

We did get a tiny correction in the first week of the year, but then the markets continued to push into unchartered territory despite the probability of the March rate cuts continuing to fall.

To some degree, the market’s resilience suggests investors are happy to see strength in US data despite high-interest rates.

Investors are confident that we have reached peak interest rates and monetary policy will be loosened anyway, if only a little later than expected.

Still, skeptics would argue that investors are under-pricing the risks they are facing.

Rising shipping costs as a result of the Red Sea situation are only going to boost input costs and lead to more global inflation, thereby delaying interest rate cuts even further.

Another factor that might worry investors is the lack of participation from non-tech stocks. Some 14% of the S&P 500 is made up of Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL), alone.

Any weakness in these or the other big 5 tech stocks in the so-called Magnificent Seven could lead to an outsized correction in the S&P 500.

With Tesla’s underwhelming results, some investors are now left wondering whether they have pushed stocks too high, too soon.

Indeed, it is the pace of the rally that has some investors worried, arguing that the optimism surrounding artificial intelligence could be a sign of irrational exuberance, especially with many companies yet to monetize generative AI effectively.

US investors have also ignored the struggling Chinese markets and concerns about the health of the world’s second-largest economy.

There are also fears, as indicated by rising yields, that major central banks around the world will not be in a rush to cut interest rates after all.

Today, the ECB President is likely to suggest that borrowing costs will not come down before the summer because of concerns over inflation.

In the US, the markets have been soaring in recent months because of AI optimism and expectations over the Fed rate cuts in 2024.

But the rally could stall moving forward. Gold, FX, and bond market investors have already shown concerns over the Federal Reserve's potential inclination to maintain higher interest rates for an extended period beyond market expectations.

Equities have been propelled to new highs mainly because of the top 7 tech companies and the A.I. optimism. There is a risk that once this optimism fades, US markets may face a correction from these overbought levels.

The trigger could be if we see signs of inflation remaining sticky or rebounding again. The Fed’s favorite inflation measure, the core PCE price index, is due for release on Friday.

We have already heard hawkish talk from several Fed officials. Even the centrist Raphael Bostic was a bit more hawkish than expected, mirroring several other of his FOMC colleagues who have spoken lately.

The Fed might provide a more hawkish policy decision next week than it conveyed in December.

S&P 500 technical analysis and trade ideas

With the major US indexes hitting repeated all-time highs this week, the trend is bullish, and markets remain in the “buy-the-dip” mode, at least for now anyway.

But the rally is starting to look a little over-stretched at these levels as one can see on the S&P 500 Futures chart.

Momentum indicators such as the Relative Strength Index (RSI) are at or above “overbought” levels, which may encourage some profit-taking.

The market’s structure of higher highs and higher lows means the bears are largely sitting on their hands and will need to see a clear reversal pattern emerge before entering the fray in large numbers.

Wednesday’s small, inverted hammer candle was formed at around the 161.8% Fibonacci extension level at 4927 of the drop from the December peak.

This may be an indication that traders will proceed with more caution moving forward, especially in light of Tesla’s earnings miss.

Wednesday’s price action will put short-term support around the 4890-4900 area into focus today.

A decisive break below this level could see the S&P 500 drop back to the shaded area on the chart around 4808 to 4841, an area corresponding to the previous two all-time highs hit in January 2022 and December 2023, respectively.

Even if the market falls to this area, this won’t necessarily be a bad thing or a sign of a peak. For indeed, many dip-buyers might be lurking to get on board any short-term dips.

But if we then start to see a breakdown in the market structure of higher highs and higher lows, that is something that will catch the attention of the bears.

At the current state of the markets, the low from last week at 4746 might be the line in the sand for many short-term bullish traders.

A potential move below this level would create a lower low and break the short-term bullish trend line.

It would therefore present an objective exit signal for the bulls. So, if that level is breached, only then can we expect to see some follow-up technical selling.

Any weakness in the interim should be seen as a normal pullback you tend to see in a rising trend.

***

Take your investing game to the next level in 2024 with ProPicks

Institutions and billionaire investors worldwide are already well ahead of the game when it comes to AI-powered investing, extensively using, customizing, and developing it to bulk up their returns and minimize losses.

Now, InvestingPro users can do just the same from the comfort of their own homes with our new flagship AI-powered stock-picking tool: ProPicks.

With our six strategies, including the flagship "Tech Titans," which outperformed the market by a lofty 952% over the last decade, investors have the best selection of stocks in the market at the tip of their fingers every month.

Subscribe here for up to 50% off as part of our year-end sale and never miss a bull market again! Use Coupon Code: Canada2024 for an extra 10% off.

Disclaimer: This article is written for informational purposes only; it does not constitute a solicitation, offer, advice, or recommendation to invest as such it is not intended to incentivize the purchase of assets in any way. I would like to remind you that any type of asset, is evaluated from multiple points of view and is highly risky and therefore, any investment decision and the associated risk remains with the investor.

Read my articles at City Index