“While the losses in the indexes have been significant since they marked their highs in April, they aren't unusual.
Rebounds from history's nastiest bear markets have involved a huge move up of 50% to 100%, then a significant correction, and finally a second leg up. The average correction was about 21%, the median 19%.
So if this correction proves typical, it may have a bit more to go before the indexes find a bottom, turn up and deliver a follow-through day.
Historically, the second leg up offers a much smaller percentage gain than the first leg. The median gain was 27%.”
O’Neil lays out an idea of how bad things can get. Do they get that bad? Nobody knows for sure, but you can start to be proactive by looking into the internals of the market and identifying what is working and what is not. When you get into periods of weakness, you are better able to see areas of strength.
You can also anticipate key zones and see how markets act in those areas.
Oversold
The Percent of Companies trading above their 50-day MA has fallen to 12%. This is an extreme reading and tells you that the markets can bounce higher at any moment. In the last Bull Market, these extreme readings were buying opportunities and led to nice rallies. However, in the last Bear Market, they only led to bounces or pauses that allowed the markets to work off their oversold conditions before falling to new lower lows.
The obvious question now is does this oversold condition lead to a strong rally or a weak bounce?
The markets are clearly narrowing, with the Bullish Percent now below 50 (Red Arrow), so fewer than half of the NYSE stocks are trading in uptrends. Boy this spike down sure looks like the first Lehman panic in the Summer of 2007…
Strength
Remember, as Bull Markets mature, there are areas of the market that lift prices higher and other areas that hang on for the ride up. Things may be different this time, but history has taught you to focus on the leaders.
Several areas of the market are still holding above their 200-day EMA (Exponential Moving Average). This is the line used by trading services, like Mutual Fund asset allocation newsletters, to determine if stocks are in Bull Markets (Above the Line) or Bear Markets (Below the Line).
The indexes for Small Caps, Mid Caps, The NASDAQ and the S&P 500 Equal Weight are all above their 200-day EMAs.
Sectors like Industrials (XLI), REITS (IYR), Semiconductors (SMH), Retail (RTH), Consumer Staples (XLP) and Consumer Discretionary (XLY) are all above their 200-day EMAs.
Obviously, breaking these levels from here would be very bearish.
Line of Death
The following are barely holding on at support and need to get defended soon or they will put some serious pressure on the Indexes.
The S&P 500, The DJIA, Large Cap Technology (XLK), Basic Materials (XLB) and South Africa (EZA) all have very important support right below current prices. They are below their 200-day EMAs and underperforming leading areas.
Potential Reversal Patterns
I noted the following pattern for Silver (SLV) a few weeks ago –
“Here is the daily chart of Silver (SLV). I have highlighted the expanding price volatility pattern. It looks like a cone. This tells you there is significant indecision in the Institutional Investor camp. Again, this is one of the best reversal entry patterns there are.”
There was an overshoot on the upside, but the pattern played out, with SLV having a nasty correction over the past 7 trading days.
The reason I bring up this pattern, is that it is potentially setting up in many markets, sectors, countries and commodities. They may all fail, but it is worth noting that a very good potential reversal pattern is in place for lots of key stuff.
Keep in mind, than the pattern does not always play out like what occurred with SLV. Sometimes it fails completely, other times the reversal is simply a small bounce or a pause in the current trend. That is why I also wrote the following about SLV that day –
“I would like to see Silver reverse lower from here and give me an entry point near $17.75. If it shows up I may take. If it doesn’t then I will buy pullbacks from higher levels.”
Failures of this pattern have often led to some pretty extreme trends.
Areas with this pattern are The NYSE ($NYA), Energy (XLE), Australia (EWA), Emerging Markets (EEM) and South Korea (EWY).
Potential Tops
As the Bull Market matured in 2006 and 2007, key leadership sectors began to top out and roll over. When the markets would rally to new highs, these areas would not. When the markets would correct, these areas would put in lower bottoms. The following areas look pretty nasty –
Healthcare (XLV), Biotech (IBB), Utilities (XLU), International Developed (EFA), The EU Zone (EZU), Latin America (ILF), Taiwan (EWT), China (FXI) and Brazil (EWZ). The commodities have rolled over with China and those stupid tax laws proposed in Australia, but that could change on any day, and all it would take would be a policy change inside of China to allow for more leverage or some new “stimulus”. So be watching these areas closely for new policy decisions.
Is a 123 Lower Top now in place for Latin America (ILF)? Brazil (EWZ), Europe (EZU, EFA) and Taiwan (EWT) look worse.
Leadership
There are still leading stocks that look great, but they are getting fewer and farther between and their price volatility is incredible.
There are also a number of past leaders that are failing – Google (GOOG), Priceline (PCLN) and Green Mountain Coffee (GMCR) come to mind.
Conclusion
The market fear is similar to the “Panic of 2008. Foreign credit and equity markets are under stress. There has been intervention in the Euro market, and also some short covering, but the US equity market needs all the help it can get from a rebound in the Euro.
It was not a system error when the market tanked last week. The SPX 1055.69 low Fri took out the 2/8/10 1056.51 low close, so that is obviously technical damage, and this is not a normal correction in a bull cycle, but it is a “Euro Zone” panic that is taking the US market along with it.
If the SPX and INDU don`t reverse and hold their 200DEMA`s on the next rally, the market timers and many hedge funds will be forced to reduce allocations even more, which will accelerate the selling and, then the SPX 38.2% Retracement at 1,010 and 50% Retracement 943 will be in play SPX. The bearish hype by the media will snowball it the SPX declines -20% or more, which is the 975 level.
Keep in mind that the June 2009 correction only was 23.6% of the uptrend and the January 2010 correction was 38.2% of its previous uptrend.
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