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The Correction Arrives, Now What? at Trader’s Narrative

The Correction Arrives, Now What?

After trading within a tight band for the past 7 previous trading days, the stock market embarked on its much awaited correction today. Last week (to the day) we went over the reasons for a short term pullback as provided by Lowry Research: distribution and an overstretched rally.

Their expectations were for a correction that would take the S&P 500 index back to the 1115-1110 range. And here we are, at the top of that range so soon. Since July 2009 we’ve seen very shallow and quick corrections. In fact since then, the S&P 500 has spent almost no time below its 50 day moving average.

I suspect that the “buy the dip” mentality has been cultivated by the professional managers who feel the pressure to bring in performance at least as good as the major market indexes. What better way than to jump onboard as soon as the market offers them a small discount off “retail”. So will they bite again?

Volcker’s Rule & Corporate Personhood
Don’t buy the media explanation that this is caused by Obama’s “Volcker Rule” announcement. There has always been some explanation offered whenever the market makes a move and it is always in hindsight and wrong. The news doesn’t really matter. What matters is the sentiment within the market and how that determines the response to the news.

The credit crisis in the US has been wretchedly mishandled. If the government had only taken a slug of equity in return for bailing out the banks we wouldn’t be in the mess we are in now. And yet, something must be done because the “too big to fail” are even bigger now. But if the “Volcker Rule” didn’t steal the headlines, the explanation would have been left up to the Supreme Court’s disastrous decision to award corporations carte blanche to set the political agenda by awarding them the same rights as individuals to freedom of speech. (By the way, if corporations are “persons” now, does that mean that slavery is back? After all, don’t we have one corporation “own” another?)

In any case, let’s get back to the technical underpinnings of this market. While the bears finally have a respite, let’s not get carried away. After all, the market is only 3% from its recent high (S&P 500 & Dow Jones).

Of Breadth & Corrections
Even so, the percentage of stocks trading above their 50 day moving averages has deteriorated markedly. For the S&P 500 index it is now just 62% and for the Dow 47%. These are sharp drops within a matter of days. The percentage of stocks above their 50 day moving average for the S&P 500 index fell by 26.2% points from January 11 2010. But the key for me will be whether this breadth measure is able to sustain its higher lows as it has since March 2009:

percent SPX above 50 MA Jan 2010

Looking at another measure of breadth we see a similar picture. The short term moving average of the Advance Decline breadth line for the Nasdaq is off its recent high and falling. But it has yet to reach a level which has marked an exhaustion point for previous corrections:

nasdaq adv dec 20 day MA Jan 2010

As Lowry’s Tracy Knudsen mentioned, the key will be how the market reacts to a correction. In and of themselves, profit taking counter trends are healthy and necessary. And we’ve seen quite a few (although short lived ones) since March 2009. If the market can’t bounce back from an oversold condition, then we are looking at a much more serious deterioration. We aren’t there yet as the breadth data shows but this is what I’ll be monitoring.

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