Significant Market Correction May Be in Progress Now

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Includes: SH, SPY
by: Steven Vincent

I've been long SPX since the September 2010 bottom and an aggressive buyer on pullbacks. Today I exited all long trades and went to 100% cash and then even took on a small short position. My current analysis shows ample reason to conclude that stocks and commodities are in the early stages of a significant correction. Here's my SPX trading record for 2011:

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I've just completed a review of recent mainstream and alternative financial media. Bears are virtually nonexistent. Almost no one is looking for any kind of a top at this time. For over two years, even the slightest sign of market weakness and every bit of bearish news has been greeted with a cascade of calls for the end of civilization. Apparently sentiment has turned fully bullish for the first time, just as the markets are signaling the potential for a deep pullback. The traders on CNBC Fast Money were completely unfazed by recent market action:

"The market feels vulnerable but it's felt vulnerable a number of times," says Fast trader Guy Adami. Largely Adami and the other traders aren't terribly concerned by Wednesday's sell-off; they expect a bounce. "On the dip you can buy," says Pete Najarian. "I'm with Pete," echoes Joe Terranova.

And in an environment like this, the Fast Money traders always suggest looking for pockets of strength and putting money to work.

I had called for a crude oil, silver and commodities top and a temporary bottom the the dollar to the very day and expected to see a significant correction over a period of weeks or months. But I was somewhat surprised by the ferocity of the market action. I'd been quite bullish on equities, as I said, and the commodities action caused me to re-evaluate my analysis of equities. Experience has shown that a market event like the commodities crash is often a harbinger of further selling, particularly when its significance is universally dismissed, as has been the case in this instance. It seems to me that complacency reigns supreme at just the wrong time and that most market participants are about to be caught on the wrong side of the markets.

My long term view remains bullish on both stocks and commodities, but there is a clear chart, liquidity and sentiment setup for a major correction at this time. The chart setup is supported by negative divergences spanning the February to May time frame between SPX and many breadth and momentum indicators. There is also an apparent excess of bullishness and an overcommitment of professional traders to the market, all of which combines to produce the potential for a sudden, large sell off.

The fact that this condition is almost universally ignored by traders and investors is coupled with very high bullish readings on a number of sentiment indicators and very low cash positions among funds and individual investors, creating an excessively bullish intermediate term sentiment environment.

FUNDAMENTALS

Earnings season is largely behind us, so the late buying power that enters the market on news has been largely disbursed. The Fed is winding down QE2, so that font of liquidity is drying up. Another round of European sovereign debt crisis appears to be gearing up. Greek debt is on the agenda this week and the Dominique Strauss-Kahn scandal at the IMF may be enough of a trigger to spook markets. The Treasury-EuroDollar Spread ($TED) has been edging higher since the beginning of February coincident with the beginning of this correction, which may indicate impending trouble in the interbank credit market. Next week the U.S. government debt ceiling issue is also on the front burner. President Obama is making scary noises about the "unravelling of global finances" that may also contribute to tipping markets over the edge into a wave of selling. Leading economic indicators have been slowing and the consensus for Thursday's report if for a 0% increase. Tensions appear to be increasing in the Middle East again and could erupt onto the front pages any time. When a market is set up for a correction, fundamental news has a way of showing up at just the wrong time to trigger the selling.

Markets tend to correct this kind of scenario sharply and suddenly, and there is good reason to believe that process is under way now.

CHART SETUP

Here's my current view of SPX on the futures chart:


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There are quite a few alternate scenarios. But at the moment, this is my preferred scenario.

  • What is being corrected? The wave 3 of (3) move from the September 2010 bottom.
  • What kind of correction is it? An ABC flat correction for wave 4 of (3)
  • Where are we in the correction? Apparently starting iii of C of 4 of (3)
  • What is the target for the correction? Strong support should be found in the zone of the lower rail (blue) of the entire move from March 2009, the 200 EMA, the April 2010 high, the November 2010 high, the March 2011 low, and the 38.2% Fibonacci retracement of 3 of (3).
  • Is the correction shortable or should a trader stay in cash? That depends on your style of trading. The magnitude and timing of the likely correction should make it shortable for the intermediate term swing trader.
  • Could this be wrong and could the uptrend continue? Of course! A wide variety of factors would seem to indicate that a significant correction is imminent. There's no guarantee at all that support will not hold. Although the risk/reward picture favors the downside for the first time since August 2010, this is still a countertrend trade, which is always a dangerous proposition. There is significant risk that we will be caught out of position when and if the bull market resumes its upward trajectory. Cash is largely a countertrend trade (and short certainly is) in this environment. But this should be as good a setup as we can hope for to either take profit and re-enter at a lower level or even make a little money on the short side. The correction actually began in February with a three wave move down for wave A. The move off the March low was also a three wave move for wave B. That wave ended with the "Bin Laden Is Dead" spike (a classic wave ending news event) and wave C began. We'll get confirmation that C down has begun with a move below the recent low. That could come as soon as Monday, but most likely by Wednesday.

We can see confirmation of the ABC corrective pattern by observing other markets and ratio charts which are showing similar ABC setups in even clearer terms since February:

Technical charts also show bearish divergences with underlying price that go back to January or February, confirming that the markets have been correcting in a sideways ABC pattern for the last few months. Here are just a few examples; there are many more:

These indicators are now showing signs of being ready to roll over into bearish territory as the market corrects. Eventually they should reset into a buy position (if the bull market is to continue) and we will look for bullish divergences to help us identify the bottom of the correction.

The correction should be fast and scary and should bring out the bears in droves. No doubt figures like Bob Prechter will be making the mainstream financial media rounds next week. The function of the correction, in the context of a larger bull market, will be to force cash positions higher and reset sentiment to bearish levels again, setting the stage for a renewed bull move.

LIQUIDITY SETUP

The fundamental fundamental for this market is liquidity. If the supply/demand balance in the market for stocks remains favorable to the demand side, then prices will continue to rise. When that shifts to the supply side, then prices will fall. As we know, the Fed's QE2 program is coming to an end soon and there aren't any good reasons to think it will be replaced with any similar effort. We're also seeing a move back to the safety of Treasuries and away from risk since February, as indicated by the ratio between the stock market and Treasuries markets:

We're seeing some interesting divergences between market professionals and the general investing population. The data is showing that professionals are excessively bullish and heavily invested in stocks and are holding very low cash levels, while non-professionals are uninterested in stocks and invested heavily in bonds.

The following charts are from Sentimentrader.com. First, let's look at market liquidity as measured by cash levels:

Rydex funds are used by market professionals. Rydex fund cash positions moved sharply lower recently even as the market hovered near its highs:


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Rydex Bull/Bear asset allocation is stretched far to the upside:



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Mutual Funds are apparently totally committed:


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Money Market fund levels are at levels previously associated with tops:


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SENTIMENT SETUP

The following four charts show that sentiment surveys of market professionals indicate a very high level of bullishness:


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The AAII survey of the general investor population shows a low level of interest in stocks, however.


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While investors are allocated to stocks, the levels are much lower than the professional segment and bond allocation is much higher, while cash levels are also very low.


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Overall the picture I am seeing is a setup for a surprise intermediate term decline that scares professionals out of their apparently overconfident complacency and forces cash levels up to a more sustainable level. If the general investor base joins in the next rally off the bottom with the professionals, that may mark the end of the long lateral bear market and the onset of a new long term bull phase. On the other hand, this same setup could produce the end of the bull market from the March 2009 low. Certainly we will need to reevaluate the total picture at the coming bottom to determine whether it represents a long term buying opportunity for investors.

Disclosure: I am short SPY.