A Plan to Weather This Correction
03/07/2012 10:45 am EST
The sharp declies in major global stock indices on Tuesday is likely to be followed by an oversold bounce before a deeper correction ensues and more favorable buying opportunities emerge.
Since December 21, 2011, the S&P 500 had not touched its 20-day exponential moving average (EMA) until Tuesday when it closed almost 1% below it. ETFs like the Spyder Trust (SPY) gapped below their 20-day EMAs.
As I said last week, the sharp decline in the Russell 2000 Advance/Decline (A/D) line sends a strong warning that investors “should not get caught up in the euphoria at current levels.” The market internals were very weak on Tuesday, and they have confirmed the deterioration that has been evident over the past few weeks.
In recent weeks, it seems as though many were waiting for a correction to buy. Stock index futures were higher in early-Wednesday trading, and a higher close may have some wondering whether Tuesday was the day to buy.
- The daily uptrend (line a) is at $132.80 with the 38.2% retracement support at $131.19, which is 2.6% below Tuesday’s close
- There is more important support in the $130 area, which would equate to a 5.9% decline from the highs
- The S&P 500 A/D line broke its short-term uptrend, line b, on February 29. It rebounded to test the uptrend before dropping sharply
- The A/D line is still above the support at the November highs, and the uptrend, line c. The weighted moving average of the A/D line is now starting to flatten out
- On the daily chart, there is initial resistance at $135.69 and the 20-day EMA
The hourly chart of SPY shows the gap through the uptrend, line d, as prices hugged the hourly Starc- band for most of Tuesday’s session. The daily Starc- band has also now been reached.
- The hourly chart shows further support in the $133.70-$134 area
- The hourly on-balance volume (OBV) broke its uptrend (line e) last Friday afternoon
- The hourly chart shows initial resistance at $143.20 with stronger resistance in the $135.80-$136.20 area
- The hourly Starc+ band is now at $135.69, which matches up nicely with the 20-day EMA
For more on trading with Starc bands, click here.
The PowerShares QQQ Trust (QQQ) also gapped to the downside on Tuesday but did manage to close above its 20-day EMA at $63.37.
- A drop below Tuesday’s low at $63.23 will increase the chances of a decline to the $60.60-$61.40 area. The 38.2% Fibonacci retracement support is now at $60.42
- The daily uptrend, line b, and the 61.8% support are in the $58-$59 area
- The Nasdaq 100 A/D line just staged a marginal upside breakout last week and has now dropped below its weighted moving average
- The uptrend (line d) in the A/D line is now being tested with further support at the late-January lows
- There is now initial resistance at $64 with stronger resistance in the $64.50-$64.70 area
Large-cap stocks were also hit hard on Tuesday, as the SPDR Diamond Trust (DIA), which tracks the Dow Industrials, closed down 1.6% and well below the 20-day EMA at $128.66. The uptrend, line f, is just a bit lower.
- There is stronger support in the $125-$126 area, line e, with the 38.2% Fibonacci retracement support from the November lows at $123.30
- The Dow Industrials A/D line has been declining for the past two weeks and has now decisively broken support at line g
- There is initial resistance at $128.40-$128.80 with stronger resistance at $129.50
What It Means: The current technical readings suggest a high likelihood that the correction is not yet over. On a short-term basis, the market has become quickly oversold, and on Tuesday, only 270 stocks were higher on the NYSE while 2805 stocks were lower. This has dropped one of my favorite short-term A/D indicators, the McClellan oscillator, down to -283. It was at -300 on November 23, 2011.
If stocks close higher on Wednesday, we could get another day or more on the upside before the major averages again turn lower and likely drop below Tuesday’s lows.
There is plenty of headline risk as well, with the current Greek bond swap offer expiring Thursday and the monthly jobs report due out on Friday.
Also, the widely expected release of the new Apple iPad could disappoint the tech sector, which is vulnerable to a sharper correction. In order to reverse the current deterioration in the market internals, the A/D ratios will need to be very strong.
How to Profit: Traders or investors who want to hedge their long positions could look to buy the ProShares Short S&P 500 (SH) at $37.28 with a stop at $36.72 (risk of approx. 1.5%).
For remaining long positions in the PowerShares QQQ Trust (QQQ) from $56.34, raise the stop to $62.94.
For remaining long positions in the Select Sector SPDR - Technology (XLK) from $23.44, raise the stop to $28.29.
Find all of Tom’s recent market comments on his columnist page.