Thursday, June 11, 2015
It looks like the stock market is entering a correction phase...
With the breakdown in the high-yield bond market, the sharp recent increase in the 10-year Treasury yield, and the record high level of New York Stock Exchange (NYSE) margin debt, the stage is set for a significant correction.
We haven't seen a 10%-or-greater pullback in the broad stock market since November 2011. So we're certainly overdue for one now. And I think the action we're seeing this week is the beginning of that sort of move...
Take a look at this updated chart of the S&P 500...
As of Tuesday's close, the S&P 500 was trading only about 2.4% below the all-time high it made last month. So many folks might argue that it's premature to talk about the market entering a correction phase.
But on Monday, the index decisively broke below its 50-day moving average (DMA).
The 50-DMA is widely seen as the determining point between an intermediate-term bull and bear market. Assets trading above the line are in bull markets. Assets trading below their 50-DMAs are in intermediate-term bear markets.
And on Tuesday, the nine-day exponential moving average (EMA) crossed below the 50-DMA. This "bearish cross" tends to kick off downtrends in the market.
So these are both bearish events.
Traders need to be cautious here with new long positions. It's likely that for the next few weeks, the best money-making opportunities are going to be from the short side.
Having said that... stocks are extremely oversold right now. They don't offer good, low-risk/high-reward setups at the current level...
The NYSE McClellan Oscillator ("NYMO") – a measure of overbought and oversold conditions – closed Monday near the -60 level that points to oversold conditions and often occurs just before a bounce in the market.
It also closed below its lower Bollinger Band. Bollinger Bands measure the most likely range for a stock or index. Any time an index moves outside of its Bollinger Bands, it indicates an extreme move – one that is likely to reverse.
Meanwhile, on Monday, the Volatility Index ("VIX") – the market's fear gauge – closed above its Bollinger Band. This is a sign of extreme fear in the market. When the VIX comes back down inside the bands, it will signal a broad stock market buy signal.
Traders rarely make money selling stocks short into oversold conditions. Even a modest stock market bounce can create losses on poorly timed short trades.
The correct strategy in this situation is to wait for a bounce to relieve the extreme oversold conditions in the market and to set up lower-risk short trades.
For example, a bounce back up to the 2,100 level on the S&P 500 would put the index right at the resistance line of its 50-DMA.
Traders could then short the S&P 500 and profit if resistance holds and the index declines. On the other hand, if the market simply runs right through the 2,100 level, traders can keep a tight stop just a few points above that resistance line and limit the potential loss.
Conditions are oversold enough now for us to be on the lookout for a small bounce in the market. Any further decline today or tomorrow will stretch the proverbial rubber band even farther and set up an even stronger bounce.
After this bounce, it's likely we'll then see a significant decline – somewhere in the 7% to 10% range.
Best regards and good trading,
As Jeff mentioned, the record-high NYSE margin debt is just one of the factors setting the stage for a market correction. And this kind of leverage destroys investors. "Leverage is financial crack," he writes. "The first hit feels good. It's a trader's high... We want more of it. So we use it again, and again, and again – until we're addicted." Eventually, though, "it kills us." Learn more here.