Stock market outlook: Technical signals say 3-wave S&P 500 correction is underway

Pedestrians on Broad Street near the New York Stock Exchange

Pressures from the Iran war are fading, but stocks are headed for a tough time this summer, Bank of America is warning.

Technical strategists at the bank said they see a cluster of signals that suggest the S&P 500 is heading into a corrective phase through the third quarter. In the end, the index could see what Bank of America calls an “abc correction” — a decline that comes in three distinct waves, strategists wrote in a client note on Friday.

“Summer roadmap is a three-wave correction. Potential for double correction,” a team led by Paul Ciana, the global head of technical strategy at BofA, said. “Be cautious if a marginal new high toward ~7,741 occurs as it may be a ‘bull trap’ consistent with an expanding flat.”

Ciana’s team said they saw the S&P 500 tipping into a correction sometime in the third quarter, which will likely manifest as a “sideways-to-lower” pattern. In the worst-case scenario, the bank sees the S&P 500 dropping as low as 6,850 during the corrective phase, implying a 6% drop from the index’s current levels.

These are the three warning signs for stocks that Ciana’s team is eyeing:

1. The S&P 500 is seeing diverging momentum

When momentum diverges from an asset, the price of the asset rises, but not as quickly as momentum gauges like the Relative Strength Index suggest. That can be interpreted as a sign that buying power for that asset is fading, and the ongoing price trend is at risk of reversing.

The S&P 500’s 14-day Relative Strength Index is cooling from its earlier high, clocking in at around 49 on Friday.

2. The index flashed a “red 13” exhaustion signal

The bank pointed to the TD Sequential, a technical indicator that can signal when an ongoing stock trend has been exhausted. When the indicator flashes a red 13, that’s a sign a rally has lasted for so long that it risks running out of steam.

The S&P 500 flashed a red 13 on June 1, Ciana noted.

3. The index entered the fourth wave

This refers to the Elliott Wave Theory, a framework for technical analysis that says that markets follow a cycle made up of five waves. The fourth wave is a small pullback before the final phase of the market cycle.

The S&P 500 traded around 7,334 on June 10, a low that likely represents wave four, the strategists said. If the index were to drop below that level, that “reinforces that a corrective phase is underway,” the bank added.

Despite expected volatility heading into the fall, strategists said they remained bullish on stocks overall. In the fourth quarter, the bank sees markets rebounding from the potential correction, possibly in a “Santa rally” at the end of the year.

Doubts have started to swirl around the strength of the bull market, particularly as the stunning rally chips and memory stocks this year takes a breather. The Nasdaq 100 ended the week around 4% lower, with much of the pain being concentrated in names like Broadcom (down 10% for the week), Nvidia (down 8%), and Intel (down 7%).

Jennifer Sor is a reporter at Business Insider. She covers financial markets and the economy, with a focus on retail investing, job trends, and the pursuit of wealth. She regularly speaks to famed forecasters and top investors in markets, including Gary Shilling, Nouriel Roubini, and Larry McDonald. Her work has also been featured in outlets such as Forbes, Bloomberg Opinion’s “Money Stuff,” and SiriusXM Business Radio. Prior to her time at BI, Jennifer covered tech and business news at the San Francisco Chronicle and Los Angeles Business Journal. She graduated from the University of California, Santa Barbara with a bachelor’s degree in economics and English.Have an interesting story to share? Please reach out to her at jsor@businessinsider.com or @jennreports.81 on the encrypted messaging app Signal. She can also be reached on LinkedIn.Story highlights