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Short-Term Market Correction Or A Change In Fundamentals?

Jun. 05, 2013 8:45 AM ETSPDR® S&P 500 ETF Trust (SPY)
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As of the close of Tuesday, June 4, 2013, the daily chart of (SPY) shows a 38.2% Fibonacci retracement of the rally from mid April to its all-time high and a support near the 30-day simple moving average. But the short-term market direction at this point in time will depend on the state of the underline fundamental conditions that fueled the rally and not on technicals. The main forces behind the rally in stock prices were persistent investor buying and the FED resolve to avert deflationary pressures. The agents behind those forces may be bluffing now for their own reasons. Longer-term investors want to add to their positions and thus they need dips and the FED does not like to reward speculators and often issues conflicting signals.

The bluffing by investors often facilitates weak hand shakeouts and that by the FED intends to punish short-term speculators in favor of value seekers. It is impossible to know conclusively whether the underline fundamental conditions have changed although different media sources attempt to promote their own views maybe depending on their vested interests. What we can know with some satisfactory rate of success based on past market behavior are the technical conditions that are associated with the state of fundamental conditions.

Scenario 1: Fundamental conditions are unchanged

According to the RSI(14) levels shown on the bottom pane of the SPY chart, the correction will stop near or just below current levels and possibly after a 50% retracement of the rally that started in mid April. Strong support is near $159.71. Then the rally will resume.

Scenario 2: Fundamental conditions are changing

According to oversold RSI(14) levels reached last November the market may correct towards support near $156 and then towards the 200-day simple moving average currently near $149.40. The correction may erase a good part of YTD gains.

In my opinion technical levels are a secondary process on top of a primary process that is determined by fundamental conditions. The relation of the primary and the secondary process is unidirectional, meaning that technical conditions very rarely determine the direction of the market but the opposite is true. Any longer-term forecasts based on technicals may be projecting cognitive biases on markets, like the notorious confirmation bias. It is quite unlikely that technical levels can forecast where the market is heading to, other than for a very short period of time in the range of a few days. It is known that long memory effects in financial price series decay after a few days and and, thus, longer-term forecasts are not justified. Any attempts to forecast the future course of markets, like weeks or months down the road, based on technicals alone may be an exercise in futility.

Nevertheless technical analysis can be a great tool for risk management. At this point in time and based on the SPY chart above the risk of a further market correction is real (scenario 2) and thus cutting down on exposure may be a prudent move based solely on risk considerations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Charts created with AmiBroker – advanced charting and technical analysis software.

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