Is the Correction Over?

05/25/2010 12:01 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

The plunge in the US stock market since the April 26 highs has been dramatic considering that in 14 trading sessions, many measures in sentiment have gone from very bullish to very bearish. The severity of the decline has caught many, myself included, by surprise. Though the decline in many individual stocks, ETFs, and mutual funds has been severe and support levels have not held, the market internals have acted stronger. In this article, I will examine how market internals such as the A/D numbers and the number of stocks making new highs or lows reflect internal strength. This is consistent with the fact that despite the fear the recent decline has caused, the major averages are still holding well above important support.

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Figure 1 - Click to Enlarge

This chart of the NYSE Composite and the NYSE A/D line shows that while this broad market average is down 13.97% from its closing high to its closing low as of May 20, the A/D line is down just 2.1%. The decline has held well above the 38.2% retracement support of the rally from the March 2009 lows, which is at 6387. This is consistent with just a correction, as a 38.2% to 50% correction is to be expected after a strong market rally, but the fact that it has happened so fast has made it seem worse to some analysts. A decisive break of the 6660 level would suggest a decline to the 50% support just below 6000. The A/D line did confirm the recent highs and while the uptrend in the A/D line going back to the July lows was violated last week, the short-term support (dashed line) is still holding. The A/D line has been leading the market higher since early-April 2009 as it moved to new highs ahead of prices (line 1). It also held up much better than the averages during the June-to-July correction (circled in green). This was also the case during the pullback in January and February 2010 (in green) as the NYSE Composite was down 9.8%, but the A/D line was down just 1.5%.

By February 26 (line 2) the A/D line was back at new highs even though the NYSE Composite was still 5.6% below its prior highs. Therefore, the action of the A/D line will be quite important over the next couple of weeks as the bullish scenario will require that the A/D line again lead the major averages higher. The short-term A/D indicators were extremely oversold last week as the as the McClellan Oscillator dropped to -417, the lowest level since October 2008 (click here for chart). 

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Figure 2 - Click to Enlarge

The Dow Transports have also been leading the market higher since the March 2009 lows. Both the Dow Industrials and Transports did make new rally highs in April, which was a positive sign. From the February 2010 lows to the April 2010 highs, the Transports were up 28.5%, while the Dow Industrials were up just 14.5%. The Transports tested the rising 200-day MA and its uptrend last week, and a close back above the 50-day MA at 4500 would be a positive sign. On the downside, a convincing break of the February lows at 3740 would be negative.

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Figure 3 - Click to Enlarge

The number of stocks making new highs confirmed the recent highs along with the A/D line as it hit a high of 647 on April 26. The number of new highs dropped to a low of eight last week. Though the number of lows rose to 161 on the “flash crash” lows, it only reached 96 last week, even though the major averages were lower. This is potentially a positive divergence. It should also be noted that the number of new lows was 805 on March 6, 2009, and this was well below the bear market high reading of 2476 in October 2008. As the number of stocks making new lows declined in late 2008 and early 2009, it supported my bullish position at the March 2009 lows. Before an intermediate-term top is completed, I would expect to see some divergences between the major averages and the number of stocks making new highs, and so far, this has not been the case.

In summary, though the bullish position is currently a bit lonely, over the next two to three weeks, the market should tell us whether or not this is the correct view. One additional reason why so many are negative on the US stock market is the recent plunge in the Chinese stock market. From a technical standpoint (click here for chart), one can make a case that it bottomed last week as long as the Shanghai A Share Index holds above the 2600 level. A bullish resolution for the S&P 500 would be for it to close above 1137, and then perhaps after a brief pullback, surge above the resistance at 1157 with very positive A/D numbers. At this point, the A/D line should again be leading prices higher. On the other hand, a bearish scenario might be for the S&P 500 to rebound back to the 200-day MA, now at 1130, on unimpressive A/D numbers and then reverse to the downside on sharply negative A/D numbers. The break below the February lows in the major averages (1044 for the S&P 500) and sectors like the financials (XLF @$13.50) would be negative and suggest a drop in the S&P at least to the 1000 area.

Stay tuned…

By Tom Aspray, Trading Lessons editor, MoneyShow.com

Editor's Note: Since this article was completed near mid-day on Monday, the weak close and Asian trading made it very likely that the recent lows were going to be broken. However, it is still my view that stocks are closer to their correction lows than their highs, and for now, the uptrend from the March 2009 lows is still intact. A daily close in the S&P 500 cash below 1042 will indicate a drop to 1000-1010. I will keep you informed via the daily charts area here on MoneyShow.com.

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