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Revisiting The Correction Playbook

Daily State of the Markets
Tuesday, May 22, 2012

Good morning. Although it took MUCH longer than just about anybody expected, the bulls finally got some relief from the corrective process yesterday as the triple-digit gain likely brought a smile to the face of anyone still long equities. However, it is important to note that such countertrend rebounds, which are also referred to as 'dead-cat bounces' in some circles, cannot be counted on as marking the bottoms of stock market corrections. Thus, we thought this might be a good time to review the way corrections typically play out.

While this time it could certainly be different, more often than not, the type of energetic bounce seen on Monday tends to be short-lived during meaningful corrections. Once the stock market becomes oversold enough and sentiment becomes negative enough, traders usually find something to trigger the urge to take profits on their short bets. Typically it's a piece of good news that causes the bears to rethink their negative thesis (at least for a day or two). But in this case, I'd be willing to bet that it was the weekend report showing that short positions on the euro had hit an all time high.

To anyone paying attention, this little tidbit of information told you that the short side of the game was getting a wee bit crowded - especially after the grinding decline that had seen just one green bar out of the last thirteen on the DJIA. Now toss in the comments from Premier Wen Jiabao which supported growth efforts in China as well as all the platitudes coming out of Camp David over the weekend and I'm guessing anyone with big short positions came into Monday looking to take profits.

The bulls will tell you that the pro-growth commentary being espoused by global leaders (well, most global leaders anyway, Germany (NYSEARCA:EWG) is still pretty intent on countries spending only what they make) will lead to a change in market sentiment. Our heroes in horns will also tell us that valuations have come in and point to yesterday's M&A deal as proof. And finally, the gang wearing the rose-colored Revo's will likely pronounce that Monday's action means that the correction is now over.

However, anyone who has been in the game for the last three years has certainly seen this movie before (as in the summers of 2010 and 2011). And anyone who has been investing for a living for a couple decades or more will tell you that yesterday's "bounce" is to be expected at this stage of the game during a market correction. So, unless investors suddenly and without any new inputs have decided that everything is going to be hunky dory everywhere on the planet, we might want to take a peek at the correction playbook and review what is likely to come next.

But before we get to the specifics regarding what we expect to see happen, there is one important caveat to offer up. In short, we must keep in mind that this remains a news-driven environment (think yields in places like Spain (NYSEARCA:EWP) and Italy (NYSEARCA:EWI), and bank withdrawals in Greece) and as such, anything can happen when headlines are made.

Getting to the matter at hand, now that the market has pulled back in earnest, creating an oversold and an extreme sentiment environment along the way, a frenetic bounce tends to occur. These blasts tend to come out of nowhere and are indeed impressive. The moves tend to be short and sharp as shorts scramble for cover. And it is important to note that the high-fliers live up to their monikers here as the likes of Apple (NASDAQ:AAPL) suddenly catch fire again. However, the initial rallies also don't tend to last more than two or three days.

After the sigh of relief bounce, the reasons the correction began tend to resurface and a "retest" of the lows usually takes place. This decline discourages anyone hoping that the corrective phase had ended and basically causes those still looking to sell to do so. This phase will also be accompanied by a "washout" where the selling becomes intense and sets up the ultimate recovery.

If the correction is news-driven, then a piece of news might do the trick to turn things around. Otherwise though, stocks will tend to go through a period of backing and filling before a sustainable rally can begin. It is for this reason that one of my trading rules after a decline tells me to ignore the first buy signal and wait until things calm down before jumping back into the pool (or back in those SSO's or UPRO's).

Turning to this morning... Despite Fitch's downgrade of Japan and the OECD's cut in its global growth forecast, stock futures have turned higher on more talk of growth measures and Eurobonds (Keep in mind that there is an informal EU summit on Wednesday.). Thus, traders will be watching closely to see if the indices can follow through on yesterday's gains.

On the Economic front... We'll get the report on Existing Home Sales at 10:00 am eastern.

Thought for the day... What are you striving for?

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: +1.19%
    • Shanghai: +1.06%
    • Hong Kong: +0.62%
    • Japan: +1.10%
    • France: +1.13%
    • Germany: +0.90%
    • Italy: +2.44%
    • Spain: +1.10%
    • London: +1.14%
  • Crude Oil Futures: -$0.13 to $92.44
  • Gold: -$8.10 to $1580.60
  • Dollar: lower against the yen, higher vs. euro, and pound
  • 10-Year Bond Yield: Currently trading at 1.785%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +5.66
    • Dow Jones Industrial Average: +34
    • NASDAQ Composite: +9.37

Positions in stocks mentioned: none

For more of Mr. Moenning's thoughts and research, visit StateoftheMarkets.com


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