Sharp Correction Scares the Bulls

06/17/2010 2:20 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

From the market highs on April 26, the decline in many of the broadest averages has been sharp enough to cause many bulls to move into the bearish camp. I was also surprised, not only by the severity of the decline, but also by the dramatic swing in sentiment. Of course, I was also critical myself, as after being bullish since near the February lows, I did not recommend that traders sell at the April highs. Though stocks are still well below the April highs, the recent rally has been quite impressive. My view on the intermediate-term trend has remained positive throughout the correction since the number of NYSE stocks making new highs and A/D line had both confirmed the April highs. The extreme oversold reading of the McClellan Oscillator prior to the May 25 lows suggested that the worst of the selling might be over. It was also encouraging that the strongest market sectors since the March 2009 lows (the Dow Transports, S&P 400, S&P 600, and Nasdaq Composite) had maintained their pattern of higher lows and higher highs.


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Nevertheless, the only explanation I could think of for the heavy bearish sentiment was the swiftness of the decline. Therefore, coming across the data from Ned Davis Research, one of the premier institutional sources of technical research, made me want to look further to see it I could find any features these declines had in common. The table above is an excerpt from their research and shows some of the shortest and deepest corrections since the early 1900's. Our current decline measured up through June 7 is 42 days in length, with a loss to that point of 12.4%, and as you can see from the table, it is nowhere near the shortest nor the deepest. Let's look at a few of the others.

Figure 1


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The chart above takes a look at two of the corrections that are on the list, and the declines, relative to the 200-day MAs, were indeed just corrections within the intermediate-term uptrend. On April 14, 1905, the Dow closed at 83.75 and then declined until May 22, losing 14.8% in 38 trading days, but it did hold well above the stil- rising 200-day MA. By November 1905, the Dow had broken out to the upside, completing its continuation pattern and reaching 103 by early 1906. Even more dramatic was the decline in late 1928 as the Dow peaked on November 28 at 295.62 and just ten days later closed at 263.90. Even thought the two-month uptrend was briefly violated, the decline held well above the rising 200-day MA. By early 1929, the Dow was again at new all-time highs.

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Figure 2


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The decline in 1950 was a bit more complex as the daily close-only chart shows the dramatic rally from the June 1949 lows at 165.70 to the June 1950 highs at 226.90. During this 37% rally, there was no significant correction, so the 13.6% decline in 38 days should not have been too surprising. The Dow had already turned lower when the North Koreans invaded the South on June 25, which took the Dow through its uptrend (line 2).  The Dow stayed below its rising 200-day MA for six days before reversing to the upside and closing back above the 200-day MA. It is interesting to note that midway through the decline, there was one very heavy volume day (see circle) that I will discuss in more detail later. This decline held above the 50% Fibonacci support level. There are some other interesting technical observations as if you take the length of the rally from point a to point b and measure up from point c, you get a 100%, or equality target, at 265 (point d), which was met in 1951. Also, if you draw a trend line connecting the June 1949 lows and the July 1950 lows (line 3), a parallel trend line from the June 1950 highs (line 1) acted as a good resistance level.

Figure 3


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The action of the market internals were quite interesting during this period as this chart from Richard Russell's chart book indicates. Richard has published the Dow Theory Newsletter since 1958. His technical work is outstanding as he was one of the few to correctly identify the major bear market low in 1974.  I have taken the liberty of adding my own notation, as even though the Dow made lower lows in July (line 1), the A/D ratio (line 2) held the March lows (line 2). Richard labels this as a DNC (did not confirm). Equally interesting to me is that the A/D ratio was already making new highs by the end of July and was once again leading the market higher. By early October, the Dow was able to overcome its June highs.

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Figure 4


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The market decline in September 1955 was spurred by then-President Eisenhower suffering a massive heart attack on Saturday, September 24 after playing 27 holes of golf the previous day. As one can imagine, Wall Street panicked on the opening on Monday, September 26, and the Dow declined over 6%. This is noted by the volume spike (see circle), but the overall correction lasted another two weeks, ending on October 11. The Dow held well above the rising 200-day MA and just retraced 50% of the rally from the March lows. It is also important that the decline held above the prior highs (line 1).  One can also use the correction from point b to point c to determine the 161.8% extension target at 520, which was hit in April 1956.

Figure 5


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During this correction, it was once again the A/D ratio that could have helped to identify this as a correction, not a change in trend. While the Dow made lower lows in October (line 1), the A/D ratio formed higher lows (line 2) and once again did not confirm (DNC) the price action, which was bullish. By early November, the A/D ratio had moved above major resistance and the previous highs (in red) even though the Dow was still well below its prior highs (point 3). This was a sign that the market was much stronger internally and was consistent with higher prices. As noted previously, the Dow hit our Fibonaacci target at 520 the following year.

Figure 6


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Unfortunately, we do not have sentiment from the earlier time periods, but I would love to look at some of the financial press from that era because I would bet that it would reflect a sharp shift from too bullish before the correction to a quite negative view after the market had declined for a couple of weeks. That is certainly what we have seen since the April highs as even some of the fundamental analysts have turned skeptical. Of course, it is too early to tell whether they are right or wrong.

Let's review the evidence, and first of all, it is critical to note that both the Dow and the A/D line formed higher highs in April, lines a and c. The daily chart above (updated through June 16) shows that the NYSE A/D line has formed higher lows, line 2, unlike the Dow, which has formed lower lows, line 1. This is similar to what we observed during the corrections in the 1950's as the A/D did not confirm (DNC) the market lows. In February, the A/D line moved through its short-term downtrend, line 1, just a few days after the lows. By early March, the A/D line was making new highs, which correctly signaled sharply higher stock prices.  A similar short-term downtrend in the A/D line was broken on June 11, line 2. It is also interesting that the volume spiked on May 21 (not shown), just three days before the market plunged on the opening and made its lows on May 25. The day before the volume spike, the McClellan Oscillator also hit oversold extremes. As we noted earlier, during both declines in the 1950's, there were also volume spikes that occurred before the actual price lows. We will be watching closely over the next few weeks to see if the A/D can once again make new highs and lead the market higher.

Tom Aspray, professional trader and analyst, serves as video content editor for MoneyShow.com. The views expressed here are his own.

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