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Post Post Mortem: Correction Scenarios

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Last week I wrote on some of the technical harbingers or aspects that might have suggested that a top was coming; patterns suggesting a possible substantial correction that was coming. Those aspects and patterns heading into this recent sharp downturn were generally not obvious, such as would be the case with a double top, although that WAS the case with the Nasdaq 100 index (NDX) and more or less the same with the S&P 100 (OEX); it made a 'line' of repeated highs at the same level, showing stubborn resistance in that area.

It may be of interest and useful to now look at some pullback scenarios. Technical analysis works to the extent that patterns and market cycles repeat themselves. For example, one past superb market technician named George Lindsey, the only one at the time with a sizable institutional following, suggested that there were 12 master market 'cycles' and any market trend would trace out one or the other of these patterns. A brilliant man on predicting the market; he was such an influence that I wrote about him in my book (Essential Technical Analysis).

Many have tried to do what George Lindsey did in his day (1950's1980's) in terms of predicting the entire YEAR ahead in terms of the market trend but no one has been able to with the same accuracy or authority. I'm referencing him here because he represented the ideas that began with the Japanese rice markets (candlestick chart concepts) and in the west, as formulated first by Charles Dow: markets repeat patterns over and over. No doubt this is because market behavior is made up of the collective actions of individuals and people's essential motivations and behaviors have not changed all that much.

So, now that I've made my little pitch for the validity of not expecting totally 'random' market behavior ahead, the following possibilities are what we might look for in the market ahead now that the first down leg of this correction may have run its course. Is it up, up and away from here? Doubtful. Such steep corrections rarely lead to a sustained advance that looked like what came before. Volatility once it comes in doesn't typically go away go quickly; as reflected in a mixed earnings/economic outlook in the year ahead, which is what drove this thing to begin with.

BEFORE GOING FURTHER, DON'T FORGET TO WRITE!

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PATTERNS OFTEN SEEN AT THE END OF CORRECTIONS

1. FINDING SUPPORT AT A PRIOR LOW

This is what the S&P 500 (SPX) has done to date, at least as measured by the late-November (down) swing low at 1378. The first significant rebound occurred from this level. It also should be said of course that it can be hard to know WHICH low will end up with enough buying interest in the stocks involved to create a definitive bottom. But, as a guide to helping make a trading decision, it was not rocket science to think that the 1380/1378 area was a good place to take some profits on SPX puts especially as lows were seen in this area two days running.

It's helpful in building a 'case' for a bottom if a prior low represents some other measure of potential support; e.g., a prior (upside) gap area or a fibonacci retracement. In the case of SPX, the area of the early-November bottom would be below the 38 percent retracement (of the July-Feb advance) level but above the 50% retracement. 38 percent tends to be a 'minimal' retracement in fibonacci terms.


2. COMMON CORRECTIVE PATTERN OF A LOWER SECOND LOW

The DOWN-UP-DOWN pattern, or an 'A-B-C' downswing pattern in wave terms, is common. The primary point to make is that often, in a major correction, the first down leg low doesn't wind up representing the bottom of the correction.

Often a rebound that retraces 38 to 50 percent of the first decline is followed by another retreat in the index to lower lows. If this occurs in the S&P 500 (SPX), as suggested by the pattern marking below, the next (lower) downswing might end in an area equal to one-half or 50% of the SPX July-Feb advance; e.g., to the 1340 area (or lower). Stay tuned on the outcome of this speculation, but one based on a common corrective pattern!


3. EXTREMES IN THE OVERBOUGHT/OVERSOLD TYPE INDICATORS

While the overbought/oversold type indicators like the Relative Strength Index (RSI) don't give us much help in making trading entry/exit decisions in options trading terms in a major bull market, once a market begins having more two-sided trading swings, they do.

If we go out to weekly chart time frame such as seen in the SPX chart below and set the 'length' (number of 'bars' to reference) equal to at least 13, we see occasional overbought or oversold levels showing up. Note that in my RSI indicator below, the 'oversold' level/line has been set at 40, instead of the usual 30/35. This higher setting (40) being the level at which for the period shown, SPX did appear to be at an oversold extreme; certainly rallies followed RSI readings at or below 40. It's not surprising to see an 'oversold' level in a bull market suggested at a higher weekly RSI level than in a trading-range or bear market.

Of course the market can be FULL of surprises, but I would anticipate that there will be a weekly RSI reading at the 'oversold' level as defined in the above weekly SPX chart before the current correction is done, especially in the seasonal March time frame which is often filled with cross currents.

4. (PRIOR) SUPPORT ONCE BROKEN 'BECOMES' LATER RESISTANCE

This technical axiom normally is said simply as support 'becomes' resistance and vice-versa: prior resistance 'becomes' support. I usually qualify this as said above to make it a bit clearer as to what is meant. In the case of a decline knifing through an area that was a rallying point on the way up (support), often a rebound back to this area will see enough selling coming in to cause a pause or to be the end point of that rally.

The dynamic here that prior lows are areas where investors bought into the market earlier; this area, this point, becomes the 'break-even' point for some or for some portions of their portfolio. When prices come back to this area and one example is suggested below, at the upper reaches of the recent rebound which carried OEX back to the cluster of its November LOWS. In this area at the blue dashed level line, I suspect that there are willing sellers who stepped up in part because its the price area where they come out 'whole' in stock bought at this level of the Index.

Note that at least this first OEX low occurred at the 38% fibonacci retracement level as highlighted below.


5. MARKET 'SENTIMENT' CONSIDERATIONS IN A CORRECTIVE LOW(S)

Often, the first low of a big correction like we've seen will be preceded by at least a 1-day bearish extreme in sentiment or the outlook for the market ahead, which I measure as occurring when total volume of CBOE equities calls is down to 1.1 times (or less) of the total put volume traded that day. This is seen graphically in my (CBOE) equities call to put daily volume ratio seen above noted at the green up arrow. As soon as the lower extreme in this ratio occurred, the next day brought a tradable low and the beginning of this recent rebound.

The sharpness of the recent correction and the fact that my sentiment indicator has rebounded quickly, suggests to me that there will be another low, perhaps a lower one, that is showing an 'oversold extreme' in this indicator. Stay tuned on that!

GOOD TRADING SUCCESS!

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for answer in Trader's Corner articles to Click here to email Leigh Stevens with 'Leigh Stevens' in the Subject line.
 

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