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Market Cracks Support – Correction Gets Serious

Written by admin | Apr, 23, 2012

sp500-daily-bollinger-042312

We wrote in this past weekend’s newsletter that there were two very important issues occurring as of the end of last week.  We stated: “First – we now have a SELL signal on a daily basis. This is disappointing but suggests that markets could decline more in the coming weeks ahead. THERE WILL BE RALLIES but they should be SOLD INTO most likely unless the upward trend resumes which will take a move above the previous highs.  Secondly, the market is currently on very important support at 1375. IF the market fails at 1375 we will most likely see lower prices in the coming weeks ahead.”

sp500-supportlevels-042312Unfortunately, the combination of weak economic news out of Europe combined with concerns over Spain’s debt dilemma sent the markets crashing through that very important support level of 1375.  The question now becomes where the next levels of support will likely be found.  As we discussed on April 11th; “Just behind that [support at 1375] is April 2011 closing high which should act as the next level of support at 1360ish.  If the markets are going to remain within the confines of a bullish trend it is critically important that these levels hold.  A pullback and some consolidation will allow for the overbought condition of the market to dissipate and allow for a lower risk entry into equity investments.”

The 1360 level is currently holding as of this writing after being tested out of the gate this morning.  As we have frequently written lately the 1st quarter advance in the market was unsustainable and a correction was due.  That correction is now well in process and has begun to work off the extremely overbought conditions that existed.  While the media is currently pointing to each every headline event as the cause for the correction the reality is that the market was due for a sizable correction simply due to the function of physics.  As shown in the first chart above when markets exceed three standard deviations from the mean the eventual mean reversion process can be quite disheartening.  This is why as investors it is always critically important that you take profits when markets are rising and overbought and begin buying when markets are declining and oversold.  Of course, due to human emotion and psychology, this is much harder to do than it sounds.

What To Expect In The Next Week Or Two

The markets are currently oversold on a daily basis which sets the markets up to bounce.  I would expect a rally attempt in the next day or two with the media attributing it to earnings related announcements such as the “Apple Rally” if there are no negative surprises in Apple’s forthcoming report.  The rally, when it occurs, will be very confined within the context of the current market environment. 

In the second chart above I have detailed two trend channels.  The original upward trend channel (green dashed lines) was broken during the current correction process.  The current uptrend line (dashed purple line) is part of the current market support level at 1360.  While the 1360 will hopefully hold there is precious little room for an advance on the upside.  The 50 day moving average is currently residing, as of this writing, at 1379ish and the previous uptrend resistance is at 1400.   Any rally to those levels should be sold into given the fact, as we stated above, that the first of our weekly indicators now on a “sell” signal. 

What Should Investors Do

The most important thing NOT to do is panic.  The biggest single mistake that investors repeatedly make is to panic sell.  Yes, the markets are declining and generally this is where investors start to make emotional decisions about their portfolio.  The markets are currently oversold on a daily basis and as stated we will get a bounce in the next few days.  However, it is also very important to remember that currently we are in a BULLISH or upward trend in the market, so it is important not to get extremely negative on the market just yet.

With the market currently on an initial weekly sell signal the rules of portfolio management change slightly.  On a rally in the market investors should institute the following processes:

  1. Evaluate current positions for excessive market risk.  (Which ones have the most downside risk in relation to the overall market)
  2. Sell losing positions on the rally to raise cash for the next buying opportunity when it occurs.
  3. Resize remaining portfolio holdings back to original position sizes to harvest profits.

These actions will clean up the existing portfolio and raise some cash which will buffer the portfolio while the correction process continues.  Also, raising some cash going into the seasonally weak summer period is just a good hedge against seasonal risk.

Important Clarification

The analysis in the post is not for shorter term traders.  For that we would be looking at hourly and daily charts.  As money managers, mostly for retirees, we are looking to manage risk within longer term portfolios.  The objective is to participant with market advances but shield portfolios against excessive declines.  Therefore, with the current initial sell signal in place we are becoming more cautious on the market until either the market consolidates enough to work off the overbought weekly condition OR the current sell signal reverses back into a “buy” signal instructing us to add equity weighting back into portfolios.  Of course, in order to add exposure to portfolios when the markets get oversold you must have cash available which is why we are suggesting using any current bounce in the markets to rebalance portfolios. 

By using slower moving weekly analysis we are seeking to mask the short term effects of market volatility.  This allows us, as managers, to capture longer term market trends, either bullish or bearish, and position portfolios accordingly.   The current economic and political environment is fraught with risks ahead from a resurgence of European crisis’ to weaker domestic economic numbers.  However, while there are many catalysts to drive media headlines, the underlying price action of the market will remain constrained by the laws of physics.   Rallies will revert to the mean and corrections will give way to strong rallies.  The difference is where you are a buyer or a seller.

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