Thursday, May 24, 2007

Technical Thursdays: 4 Reasons Why a Market Correction is Imminent

Setting aside seasonal factors (sell in May and go away; the long Memorial Day weekend ahead), I have identified four reasons why a market correction of some consequence is imminent. The four reasons noted are encapsulated in the chart to your left and are all of a technical analysis nature.

They are as follows:

1 – Rising Wedge – while a rare occurrence, chartists will tell you that a rising wedge is a bearish pattern. History shows that the narrowing of the spread between the highs and lows of the trend lines, with the lower end rising dramatically (the rising wedge), usually results in a serious reversal.

2 – Momentum Divergence – one of the most reliable short term trading indicators I have found is when price advances are not matched by momentum. The second area of the chart to your left shows an unmistakable decline in momentum as the market marched ahead to new highs.

3 – MACD – moving average divergence is another area of concern. Here MACD (third area of the chart) has gone flat, confirming momentum’s weakening of market strength.

4 – Price to 200-day Moving Average – at 9%, the gap between the current level of the S&P 500 and its 200-day moving average (arrow) matches the most recent gap (end of February) that preceded a minor (yet dramatic) market correction.

Investment Strategy Implications

Common sense dictates that market corrections are a normal, healthy aspect of a bull market. And, while it is risky business to try and be so precise in calling market turns, when equities run up in nearly a straight line, it is not exactly a low risk environment.

Note: This call is strictly in a market correction vein and not a major market top call. For that to occur, other, more substantial factors must come into play. Despite clear signs of market bubbles and highly risky this-time-is-different new era thinking, a major market top has still not been formed.

1 comment:

Brandon Chapman said...

I wanted to comment on the existence of a rising wedge on the SPX. Currently there is not enough data points to point to a rising wedge. In order to be classified as such, one would have to identify two highs and two intermittent lows. In the process the advance of the lows would be increasing at a faster rate than that of the highs. The period over which your lines are drawn would point to a relatively major formation, which at this point would only provide confirmation of one high and low. The short-term highs that were developed from Nov-Feb could only be classified as one major high that was confirmed with the drop in February. The next major low was certainly established in March, but beyond that there is nothing with which to hang the hat of a rising wedge upon. I certainly agree that there is a divergence forming as a result of the larger pull-backs over the last several weeks and the overall deceleration of the advance, but it would be premature at this point to include a rising wedge into the equation. If a top confirms shortly and we see a relatively modest retracement of less than around 100 points before bottoming, at that point it would provide substantial evidence of a rising wedge and would only require confirmation. However, that would likely take several months to develop. Thanks for your daily comments.