How I See the Market During a Correction: Where we have been, Where we are

To make sense of where we are now it is necessary to backtrack a bit. There is no place to start but at the recent multi year or all time highs for the indexes. July 12 seems like a lifetime ago now, a HUGE rally pushes the indexes out to new highs and all is right with the world. Yes, there were warnings signs a correction was pending. I will take pride writing this blog in real time so I mention these things now just as recap. Real time is what it is all about... everything else is theoretical garbage. You will see them again and anything else needed in the future in real time with further explanation.

First and foremost the NYSE Advance/Decline line ($NYAD) failed to confirm the new high in the indexes. As the name states this line shows the cumulative total of the advancers vs. decliners. This is by far the best indicator of the health of the market I have ever seen. It has never been wrong in my experience with it and was not wrong this time.


The small cap $RUT failed to confirm the breakout, but more importantly the equal weighted S&P 500 as measured by RSP, an ETF, also failed to confirm the new high in its benchmark cap weighted sibling.

The Yen which is a liquidity driver of the markets was setting up for a countertrend rally through its 50 day MA and we had clear leadership to the downside developing in financials and consumer discretionary stocks which failed to move to a new high after the February swoon.
All this was nice to see but the trend is you friend right? Can't fight that trend so there was nothing to be but bullish at the top even as you recognize the warning signs. To be anything else is asking for it as these divergences can fix themselves or perpetuate longer than you think.

On July 24 the $SPX failed its breakout and the $RUT was killed off its non-confirming highs. This was the first confirmation of the warning signs and signal that action needed to be taken. On July 26 the DJIA followed suit and left no doubt that a correction was at hand.

There are two things that are important to me in once it is recognized we are in a correction.....

1. Trying to call a bottom is futile. Leave that to the idiots who will call a bottom every day and on any bounce claim victory and then call another bottom on new lows and claim victory again on a bounce. These people are jokes and you are too if you play this game. This can show up in a couple of ways. One way is obvious.... Outright calls of a bottom due to sentiment indicators , "vibes" that we have "gone down too much" or valuations. Just don't do that. Recognize things like sentiment indicators but realize they don't REALLY mean anything unless price confirms them, just like the $NYAD suggesting a false breakout did not really mean anything until price broke down. The other way is more subtle and needs to be constantly worked on even by experienced traders.... that is the maintenance of a bullish look at the charts even though the bearish setups, trends and confirmations are all around. In this way you can accept the market is falling, not try to call a bottom in the market, but still only look at support to hold as if it means anything until the market stops going down. This would be that sinking feeling in your stomach and confusion in your mind about whether to take a trade. Deep down you know you are looking on the wrong side of the market but are not fully conscious of it. This one is hard but is worth recognizing and working on.

2. More importantly... Wherever the market does find a low, it will be tested again in the near future before a real uptrend can resume. The lows, wherever they may be put in, will be tested! We don't know if a test of wherever the lows are put in would hold. In a continued bull market it would play out like the summer of 2006 or March 2007... test of the lows is successful and then move to higher highs. In a bear market or (prolonged rolling correction like 2004) the process of testing the lows fails again and again and new lows are created which are tested but fail to new lows.... cycle continues with big bear market rallies in between until the bear market finally ends. So what we know after we identify we are in a correction and not a natural pullback in an uptrend, is that the first rally off of a low, will NOT be the bottom that leads to a huge rally. It may ultimately be THE bottom, but that can not be known and we know a test of the bottom will occur in some way.

The working assumption is that we are in a correction. This will continue until the market PROVES otherwise. Holding the test of the lows is a signal of stabilization but the end of a correction is not PROVED until a series of higher highs and higher lows is in place. This can be a slow process even as the volatility makes it seem like things are happening quickly. Recognizing the current status of this process of testing, failing, holding, stabilizing, and trending should be enough to be on the right side whether a bear market develops or the bull market continues.

So..... where are we? Indeed, we are in the process of testing, perhaps failing at the the lows. Keeping in mind that lows need to be tested in a correction and calling a bottom is futile, this should not come as a shock. Friday saw us push down to the lows and hold, with no follow through to the attempt we are now right back down at the lows today. The working assumption remains a correction until the market proves otherwise and there has yet to be any real bullish case based on price action! The devastation you can see on the $NYAD chart above suggests that this will not be a walk in the park like the Feb/March correction but will be more prolonged. No doubt the market can rise strongly at any moment but the assumption has to remain a correction until the emergence of higher high and higher lows. Wanting to act bullishly BEFORE a confirmed bounce off support and after such a bounce feeling like you already missed the move is an expression of the subtle way of trying to call a bottom. The first exposes your money to the horrors of a correction and the second puts you in an emotional spiral that can make you fail to act on the next trend still fearing the market (Yes, I am speaking from experience!). When it happens it will show us clearly that it has happened. Don't try to call in it in any form! I have marked in yellow the confirmed bounce at a successful test of the lows March 14-15 and the higher high after a higher low April 3-10 on this chart of the $SPX during the Feb/March correction. Was there any need to call the bottom and did you miss anything by waiting for confirmation? Yes, that was a very easy correction to hold through, andcame on a bit too quickly to play on the downside, but it works all the same no matter how the correction plays out.

OK.... that is enough for now. Now that the groundwork is out there I will move to closer examination of technical evidence in the chart in future posts and what I see as actions that can be taken in the different steps in the process depending on the timeframe of a trade. This is the first potential market top/entry into a bear market I have traded through and I have to say it is bringing many things full circle! Needless to say my posture remains bearish until evidence arrives to prove a change is needed.