The Recent Correction Is Not Quite Deep Enough

Includes: DIA, QQQ, SPY
by: Price Headley, CFA

A little good economic news (consumer confidence, challenger job cuts) early in the week sent stocks tumbling last Monday and Tuesday. Then a little bad news later last week (higher unemployment, factory orders) sent stocks soaring. Go figure. All told, it was the best (i.e. most gainful) week we've seen in the last four. Yet....

As exciting as the last three trading days of last week must have been for the bulls, the wild rally carried the market back into an uncomfortably overbought condition again.

That's not to say stocks can't keep rallying. In fact, the market was pretty much overbought throughout the September/November rally. Just know that without a healthy correction since the early November peak we've not seen a capitulation strong enough to really 'reload' the market and spur another big rally; from that peak to the mid-November low was only a 5.1% correction.

We'll look at that idea below, after working through some of the key economic data.

Economic Outlook

There was plenty of good news about the economy last week. The Case-Shiller Index, for instance, confirmed that home prices inched higher again, consumer confidence swelled, construction spending was up, and more jobs were created than lost.

Before popping the cork on the champagne bottle though, digest the fact that the unemployment rate moved up (by more than a little), factory orders were down, and mortgage applications plummeted.

There was more going on than that though; the entire report card is below.

As for grading the economy based on the sum of last week's data, we'd have to give it another C. In some ways that's good, and in some bad. It's good in the sense of "could be worse, while the 'bad' is that it's not a conclusive snapshot, which allows investors to interpret and reinterpret the data on a whim. And clearly, that's what happened last week.

Economic Calendar

120410-econ-calendarClick to enlarge

The coming week will be much less eventful, though important all the same. The pros are looking for another contraction in consumer credit levels (-$2.3B), which crimps the consumer spending that's needed to spur the recovery.

Of course we'll hear about new and ingoing unemployment clams on Thursday - both should be flat.

On Friday we'll get the initial Michigan Sentiment Index level for December, which at this point is expected to move higher, to 72.5.

S&P 500

The good news is, the S&P 500 jumped 35.31 points (+2.97%) last week to close out at 1224.71. The bad news is - and don't assume the worst just yet - there's a great deal of overbought pressure piling up.... not to mention a couple of other red flags.

That in itself isn't the end of the world. In fact, being reeled in now may be just what the doctor ordered. It's better to start out a rally by first establishing a good base, and then methodically working past prior highs. To simply blast through prior ceilings while still in the shadow of a 14.3% rally (from late August to early November) like we seem to be attempting to do as of last week is a setup/invitation for some huge and rapid profit taking.

Just for perspective, the average correction for the S&P 500 since March of 2009 has been on the order of 9%... and that was the average, meaning some were bigger. The smallest during that time was 7.8%. The November dip? A mere 5.1%. And the 14.3% rally that got us there in the first place? That's on the upper end of the 'normal' scale for bull market runs since March of 2009.

Point being, we're really pushing our luck here by counting on significant more upside from here without a significant selloff first.

As for what a 'significant selloff' would be, a pullback to the 1136 area would do just fine. That's where the lower Bollinger band is aligning with the 200-day moving average line, both of which have proven to be significant factors (reversal points) for quite some time. Although the idea of such a dip is alarming, it would only be about a 7.5% pullback from Friday's close. In those terms, a correction doesn't sound nearly as troubling; it would actually be a welcome release of all that overbought pressure.

And, there are a couple of hints such a dip could be brewing. One is the fading buying volume over the past three trading days. The other is how the VIX is back near its lower Bollinger band again, which is pretty much where the market has rolled over - or at least stalled for a few days - since August.

Putting all the pitfalls and red flags together technically puts the odds in favor of the bears, and against the bulls.

S&P 500 - Daily Chart
120410-sp500Click to enlarge

What the market "should be doing" and what it "is doing", however, are often two different things. As overdue as we are for a dip, we can't fight the tape. If for some reason the S&P 500 does manage to punch through that upper band at 1230 (and subsequently hit new highs), that may well be enough to jump-start another leg of this bull market regardless of driving us further into the overbought problem. 'Tis the season, after all.

The next couple of days are critical, for obvious reasons.

Industry Performance

It's been a while since we've posted an industry-ranking chart. There wasn't much need to, as everything was rallying or selling off in tandem. The same even goes for the broad sectors. Last week, however, we started to see some separation between the men and the boys... enough separation to suggest emerging leaders or decided laggards as we head into the New Year.

There's a clear theme to most of the winners... industrial materials. If it's used to build a house or a machine or infrastructure, it was hot. Just be careful though, as many of those winners are also sitting atop big longer-term rallies. Aluminum may be an area you want to really focus on first.

Many of the laggards were recently the market's leaders, proving it's not wise to try and lasso every shooting star. Indeed, some of those recent winners may now be prime short candidates now that they're starting to crumble; apparel and Internet stocks come to mind.

Best/Worst-Performing Industries Table


Trade Well,
Price Headley

Author's Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.