Since early June my market breadth driven analog model has pinpointed a potential correction in the making starting July. The market correction so far has unfolded closely following the analog. As of August 8, both S&P 500 (NYSEARCA:SPY) and Dow Jones Industrial Average (NYSEARCA:DIA) have about 5% correction from their respective year highs. Are we going to get more selling or is this time to bargain hunting?
The Market Breadth Analog Model
My market breadth analog model looks at more than 10 custom market breadth statistics to identify historical scenarios similar to current market conditions. By the end of June, the stock market behavior back in year 1990 is the one that stands out from the rest that matches closely to what happened so far this year. Armed with this information, I have a road map on hand telling us what we can expect to happen in near term.
A Visual Comparison of Year 1990 and 2014
Following is the daily chart of S&P 500 back in year 1990. The vertical line on the right side marks the date Aug. 8, 1990.
Comparing the chart above to the daily chart of S&P 500 this year so far.
The arrow markers are put there to highlight the matching market breadth events where the 2 years aligned.
The arrow markers to the right of the vertical line are put there to highlight the potential turning points based on what happened back in year 1990.
- The first date coming up is August 15 which lines up with the option expiration this month. It is marked on the first chart with the purple down arrow.
- The second date coming up is August 23-24. It is marked with the dark red up arrow.
- The third date coming up is the end of September. It is marked with the orange up arrow.
Good News For Long Term Investors
S&P 500 so far has dropped only 4-5% from year high while back in year 1990 the damage during the same period was close to 10%. This implies the current correction should not be as bad as what happened back in year 1990.
The correction back in year 1990 completed by end of September has launched a huge rally in year 1991. If the S&P 500 successfully contains the correction to within 20% like year 1990, there is a good chance the S&P 500 will do something similar in year 2015.
Good News For Short Term Traders
The bottom produced last week has only corrected some short term market internals from overbought to neutral while the rest of the metrics are getting even more extended. This implies the stock market participants are not as cautious as they should be. For a good weekly/monthly level bottom to be formed, the rest of market breadth readings will have to be corrected as well.
In short, more downside pressure is expected near term until early October. If S&P starts to pick up speed to the downside, it is not a surprise that we are going to get down to the 10% correction level.
Remember that it is not necessary for S&P 500 to correct the full 20% like year 1990 to find a bottom. Historically, as long as volatility picks up for a prolonged period of time (i.e. a month), there is a good chance for the correction to be well contained while the market internals move into oversold territory.
This is very good news for short term traders as the low volatility environment has been difficult for many active traders to find good short term trading opportunities.
The coming two months will be a difficult trading environment for longer term investors while providing very good trading opportunities to the short term traders. Once the S&P 500 starts moving lower in late August, traders should expect that a full market correction is on the way. Wait for the bottoming process to complete by October, or when the long term market internals have corrected, and it will provide very good trading opportunities for longer term traders.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.