The last 15 months have been remarkable for the economy and stock market. Both are in much better shape than seemed possible. No doubt this was abetted by the aggressive and timely policy response and the successful development and deployment of vaccines.
Since the March 23 stock market bottom last year, the S&P 500 (NYSE: SPY) is up by more than 90%. This type of strength has led to a degree of overbullishness from market participants which is evident from a variety of measures such as the historically high ratio calls being bought relative to puts, investors holding low cash positions, and the number of anecdotal indications of extreme greed such as the behavior in meme stocks. Further, on a historical basis, we know that most years have at least one pullback of greater than 10%, and this is particularly common in the second year of a bull market.
From a price action perspective, the market attempted to break out to new highs earlier this week but this breakout was viciously rejected. These breakouts tend to either lead to more buying when investors are underexposed, and selling when investors are overinvested. It also explains the market's recent behavior of selling on good news which is another indication of this dynamic. And, the weakness was focused on some of the strongest sectors of 2021 such as industrials (NYSE: XLI), energy (NYSE: XLE), and basic materials (NYSE: XLB).
Therefore, it's quite possible that we are in the beginning of an extended stock market correction that could last anywhere from one to three months. This correction will likely test important support levels, allow individual stocks to set up to more attractive, entry points, and lead to a better balance between bulls and bears. There were similar pullbacks during the last bull market that started in 2009. This was the "Flash Crash" when stocks were down by more than 10% in the spring of 2010.
Something similar may be brewing here. At the least, these circumstances should lead investors to consider taking some profits or reducing risk. It's also setting up a good opportunity on the short side with a stop at the market's recent highs. If the market is ready to decline, these levels should hold.