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In our recent post "The Correction Has Started" we stated:

The markets should find initial support at the 50 dma, which as of the time of this writing is 1371.30 to be exact. Over the next day or so this will likely be closer to 1370 as identified in the chart. Just behind that is the 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.

(click to enlarge)

Tuesday's sell off dragged the market through the first resistance level right into 1360 support level we identified. This is the first real and significant correction in this unrelenting uptrend that begin in December of 2011. On March 14th we wrote that a correction was coming but at that point the correction remained elusive. The rally at that point was already trading well into extremes but bullish sentiment and psychology can drive irrational markets even more irrational.

This was a point that Cullen Roche wrote about on March 15th:

I have to admit that the current rally is surpassing anything I would have ever expected at the beginning of the year. We're in that 'can't lose' market environment where every little dip is bought, every data point is positive and stocks literally don't go down. Here are the year-to-date stats (that's 2.5 months for those keeping track):

Germany's DAX: +20%, 96% annualized
S&P 500 (SPY): +11%, 52% annualized
S&P 500 : up 67% of all sessions, just one -1% day in 51 trading sessions.
Nasdaq 100 (QQQ): +19%, 91% annualized, up 73% of all sessions.
Homebuilders Index (XHB): +23%, 110% annualized
S&P Financials (XLF): +21%, 100% annualized
Apple (AAPL), the world's largest company: +45%, 216% annualized.

His observations are more than just amazing - they are VERY typical of market topping patterns and are dangerous. Logic will tell you that it is highly unlikely that the blistering pace set in the first quarter is sustainable, however, human emotion tends to keep investors "drinking at the party" for far too long.

Let me be clear, I am not saying that the market has topped OR that there is about to be a major crash. What is important is understanding the dynamics of how markets work so that we can better navigate the risk in longer term investment portfolios.

For shorter term traders this is a tradable bounce that could very well push back up to the 50 day moving average which currently resides near 1375. If the markets are able to clear that level then a shot back at 1400 is very likely. We are currently in a bullish market trend which is more supportive of advances versus declines. The previous leaders of technology, cyclical and financial stocks will likely lead the charge. It is critically important that the markets defend the 1360 level on any further declines if the current advance is to continue.

For longer term investors, like me, I am looking for opportunities to buy things that are oversold on a longer term basis and provide real value. The market currently is still overbought on a longer term basis and will require either a more significant correction or an extended consolidation process to reverse that condition. Until that occurs it will be very difficult for the markets to advance much further from here. Therefore, if the market bounces back towards the old highs in the next few weeks it should be a bounce that is sold into.

Let me explain why.

We are nearing the end of the seasonally strong period of the markets. The markets are still longer term overbought and have had a significant advance without a real fundamental or economic recovery backdrop. This has been the same case in each of the last two years of liquidity driven surges that peaked in April and led to more significant summer declines. Those declines have each provided much better buying opportunities for investors looking to make longer term commitments.

(click to enlarge)

The reason that I am focused on the last two years in particular is because of the market intervention by the Fed. In both cases, February of 2011 and January of 2010, the liquidity programs have driven the markets to extremes of 3 standard deviations above the mean. In each event the ensuing correction process began in April as liquidity ran its course through the system with market response the same in both times.

In both instances the market reached the same extreme overbought condition that we reached during the 2012 advance. Each time the advance was halted in April and followed by an initial mean reversion process that took the markets to 2 standard deviations below the mean. (While the current correction has not quite achieved that level - it is still possible if any rally fails at the 50 dma.) That initial mean reversion got the markets to a daily oversold condition allowing for a subsequent rally to new highs. Each time, the media quickly proclaimed that the correction was over and it was time to jump back into stocks as it was a great buying opportunity. In reality it was a "suckers rally" that lured unwary investors back into the markets as the longer term correction process had yet to be completed. It was the subsequent near 20% summer declines reset the markets for the next sustainable advance.

Today's market is no different than the last two. The fact that the media, and the Fed, are even discussing QE 3 tells you that the economy is far weaker than it should be and is surely not supportive of a 52% annualized return in the S&P 500 as Cullen pointed out previously. We can debate the issue of the cheapness of stocks versus interest rates and inflation, however, with both of those metrics artificially suppressed by government intervention what is it really telling us? As we pointed out in The Return of Economic Weakness:

The economy is a reflection of real employment, when you consider that 70% of the economy is made up of personal consumption, and ultimately the stock market is reflection of the economy. Therefore, while the markets and the real economy can detach from time to time, especially when driven by successive rounds of liquidity injections, reality will eventually play catch up with fundamentals.

With the markets currently in a bullish trend this is not the time to be heavily shorting the market. However, using any near term rally to rebalance positions in portfolios, reduce laggards and reduce aggressive risk profiles is highly advisable as we move into the summer months. There is absolutely no guarantee that this summer will play out like the last two. However, there is little risk to being more cautious especially with the potential for a resurgence of the Eurocrisis, another debt ceiling debate, the political intrigue of the coming election and the potential for continued economic weakness looming ahead.

Source: Use Any Near Term Rally To Rebalance Positions, Reduce Risk