Correction Now? Not Likely Without the Set Up.

There are certainly many justifiable fundamental reasons for stocks to take their long overdue (and healthy) corrective tumble right now but in one important aspect such a decline is not likely to occur just yet – the set up is absent.

It is an extremely rare occurrence when a meaningful correction (10%+) occurs without certain market preconditions in place prior to the decline. Absent these preconditions, market declines have an “out of the blue” quality to them and tend to be limited to the 3 to 5% range. The rationale for the preconditions (the set up) is rather straight forward – before a trend reversal can take place, weakness must begin to emerge so that the apparent forces that drove prices higher were actually exhibiting signs of exhaustion when one looks beyond the headline major indices. Typically the signs of weakness are most apparent in the form of divergences – price action divergences between the major, headline indices and other important sectors of the market.

The first chart above (click image to enlarge) shows that such a divergence had potential in November into December last year but was clearly resolved to the bull case before the year was out with higher highs being made with all size indices confirming. As the chart clearly shows, however, no such divergences preceded the current drop*.

Another aspect of the set up is the price point at which the decline takes place. For example, when a decline begins at a price point of no consequence (e.g. NOT at a moving average) the decline again has the features of an “out of the blue” style drop. Moreover, it always adds power to the decline argument when price crosses a key moving average, such as the 50 day moving average, at the same time the 50 day crosses the longer term 200 day moving average. (This is what some call the “golden cross”, which I have labeled a mega trend reversal.)

The second chart above makes this quite clear as the US market is a long way away from producing such a reversal signal. Price has broken its 50 day moving average, but it has done that several times before**. Moreover, price is well above its 200 day moving average and the 50 day is a long way from crossing the 200 day***.

Investment Strategy Implications

While there are many fundamental reasons for equities to decline (over valuation being one of them), the technicals of this market do not argue for a sustainable decline at this time.

*The same conditions are found when comparing US to various global indices.
**The above chart is only the last 6 months. Since the bull rally began in early March 2009, price has crossed the 50 day 3 times.
***The correction case would morph to the bear case should price remain below both moving averages and both moving averages point downward. Hence, the mega trend reversal.