Time for a Reality Check As Long-Awaited Stock Market Correction Arrives – Published in Noozhawk on Monday, October 13, 2014

It should be no surprise to any investor that stocks are showing signs of weakness after more than 5½ years-plus of the bull market rally. Many investors have been in denial, however, as the signs of a pending correction were quite visible, for those willing to actually look.

The Russell 2000 small company index peaked in March. From that peak, this index has fallen 13.25 percent and is now at its 52-week low. This early indicator of a shift in market direction has been largely ignored by investors, who have chosen, until very recently, to continue buying stocks. Over the past three weeks, however, the broader market indices have rolled over, and most technical indicators are now lining up — flashing red — and forecasting that a significant correction is imminent.

From its all-time intraday high of 2,019 on Sept. 19 the Standard & Poor’s 500 has fallen 113 points, or by 5.6 percent (so far), to 1,906. More alarming for those owning stocks is the fact that this index lost 62 points during last week alone, or 3.1 percent, culminating in a 1.15 percent drop on Friday.

Volatility is another key indicator of a major change in market conditions, with the VIX Index spiking up to a two-year high of 22. Trading volume jumped to 7.9 billion shares, on average, per day last week, as investors scrambled for the exits.

From a technical analysis perspective, we are finally seeing a lot of indicators lining up. This has not been the case until recently, which could explain investor complacency despite the warning signs from the drop in the Russell 2000 mentioned above. Alongside the “death cross” in the Russell 2000 (the 50-day moving average crossing below the 200-day moving average), we have seen theNasdaq Composite, the S&P 500 and the Dow Jones Industrial Average all cross below their 50-day moving averages in the past few weeks.

Even more concerning, as of Friday’s closes, the S&P 500 is sitting on its 200-day moving average, while the Nasdaq and the Dow have violated their 200-day moving averages. Although moving averages are rather simple indicators, in my experience, when they all line up together, they are a very strong indicator of future market direction.

 

NASDAQ Composite Index with 200-day moving average break.

NASDAQ Composite Index with 200-day moving average break.

 

While the Dow Jones Industrial Average has only fallen about 4.5 percent from its September peak, the Dow Transportation Index has fallen more than 9 percent. Typically when there is a divergence between the Dow Industrials and the Transports, the Transports drag the Industrials with them, which would indicate that the market is headed lower.

If we add to these technical indicators the fact that valuations for stocks are incredibly high, we haven’t had a 10 percent or better correction in three years, the Fed is endingquantitative easing this month and plans to begin raising interest rates soon, and the dollar is now strengthening (which is sure to pressure future earnings since it makes U.S. goods and services more expensive in foreign markets), we have a technical and fundamental picture that screams correction.

The tough part is determining how far down stocks will fall before finding support and eventually rebounding. While I believe the downside from current levels is significant, I do not believe we will move into a bear market. But I am expecting a short-term move down to 1,850 on the S&P 500 (right where we started 2014), with a possible short-term rebound from that level, followed by another leg down to the 1,700 level.

A fall to around 1,700 would represent a 15 percent correction. While I feel we could see an even larger drop, I would feel comfortable investing at this level, as there is reasonable support there, and valuations would be much more realistic.

It is certainly possible that stocks will rebound this week. With the S&P 500 sitting on its 200-day moving average, investors may view this as a buying opportunity, believing that the 200-day MA will hold. If this is the case, we could see some buying come in early this week, as investors attempt to drive stocks back up off of this level.

If the S&P 500 should break down through its 200-day MA, given that the other major indices have already broken through theirs, I would expect selling to accelerate. Investors should have already raised cash, and should have a detailed reinvestment plan in place so they are ready to take action when opportunities materialize.

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