After massive gains from the late August low the market's up trend is finally starting to slow. We have been talking about the potential for a market correction for weeks now and we finally got a taste of one in the last few days. In perspective the losses last week were pretty mild. The U.S. dollar rallied almost all week in spite of the Fed's new QE2 program. Commodities managed to ignore the dollar's rebound until Friday. Fears of inflation in China sparked some serious profit taking in the commodity space. Cotton and sugar were hitting all-time or multi-decade highs but managed to reverse on Friday.
Inflation fears in China were the main culprit for Friday's market sell-off. At least that is the excuse we were given. It is true that China is seeing an increase in inflation and the government told banks to increase their reserve requirements, which effectively decreases lending and business activity. There was concern that China might hike their interest rates to slow down inflation over the weekend. Worries over a rate hike pushed the Shanghai index to a -5.2% loss. The rest of Asia and Europe followed China's decline although losses in Europe were less severe and the German DAX actually managed to close in positive territory. If we do hear China raising rates soon it could spark another drop but it will probably only have a short-term effect.
Another contributing factor to last week's market losses were rising concerns over the fiscally challenged European countries (e.g. Portugal, Ireland, Italy, Greece and Spain). Ireland was the main focus of concern but the big three European nations (Britain, France and Germany) all agreed to help backstop Ireland's debt. There was also speculation that the EU might offer a broader form of support to help stave off Ireland turning into another Greece-like meltdown. The euro decline throughout the week on debt default fears, which helped fuel the oversold bounce in the dollar.
Looking at the U.S. markets you probably heard a lot of concern over the reversal and a potential bearish double top pattern. The S&P 500 index managed to hit new highs two weeks ago but the lack of follow through does indeed make this look like a possible double top (see the weekly chart below). The S&P 500's rally appears to have failed right at the 61.8% Fibonacci retracement level of the 2008 bear-market decline. Of course we have to keep this in perspective. The market had grown extremely overbought and was way overdue for some sort of pull back. The real question is whether or not the S&P sees any follow through to the downside. Currently the index still has a bullish trend of higher lows.
Traditionally, in a "normal" market we might look for a pull back to the 38.2% Fib retracement level (see daily chart). Yet that would mean a drop in the S&P 500 toward 1160-1155. There are so many investors looking to buy the dip I highly doubt the index would fall that far. While I agree that Friday's close under 1200 is technically short-term bearish I still think this index will find support in the 1185-1175 zone - an area I would look to for new bullish entry points.
Daily chart of the S&P 500 index:
Weekly chart of the S&P 500 index:
The NASDAQ Composite does appear to be correcting. The up trend was so sharp that a breakdown below the trendline of higher lows was going to happen sooner than later. This is short-term bearish but again I'm not worried. The NASDAQ was way overdue for some sort of correction. Normally we might look for a pull back to the 38.2% Fib retracement but again I seriously doubt the NASDAQ will fall that far. In spite of CSCO's earnings guidance disappointment last week investors are still focused on the tech sector for growth. I would watch the NASDAQ to find support in the 2450 area.
Daily chart of the NASDAQ index:
The small cap Russell 2000 index has rolled over under resistance near the 740 level. If this pull back continues I would watch for support near prior resistance in the 715-710 zone. Then again the small caps tend to be a little more volatile so it wouldn't surprise me to see a dip all the way back to 700. I would use this sort of pull back (715-700) as a new entry point to launch bullish positions.
Daily chart of the Russell 2000 index:
We still want to keep an eye on the Transportation index and the SOX semiconductor index. The Transports have formed a bearish reversal pattern but the trend of higher lows is still intact. We can watch for short-term support in the transports in the 4675 area. The SOX also appears to have formed a bearish reversal but broken resistance near 370 should offer some support.
This coming week we will see an increase in economic data. Monday will bring the retail sales data and the New York Empire State manufacturing index. On Tuesday is the Producer Price Index (PPI) and the Industrial Production numbers. Wednesday we'll see the Consumer Price Index (CPI) gauge on inflation. Plus the housing starts and building permit data is released on Wednesday. Then on Thursday we'll hear the Philly Fed survey for November. Given the recent turnaround in economic data I'm expecting most of these to come in line with expectations or slightly better than expected, which should help soothe investor fears and help keep the rally alive.
In summary, not much has changed. We've been waiting for a correction and it looks like a correction has begun. Keep in mind that there are a lot of investors looking to buy the dip as an entry point they can ride throughout the rest of the fourth quarter. The only question is where will they buy that dip? Given my optimistic outlook any correction is probably going to get cut short in the -3% to -5% zone. A 3% pull back on the S&P 500 would be 1,188. Meanwhile a 5% pull back would be 1164, which is pretty close to the 38.2% Fib retracement. Again, I would focus on the 1185-1180 zone for support. It can be unnerving to buy the dip sometimes so readers may want to slowly scale into positions with small chunks. That way if the dip doesn't stop you have limited your risk.