Let Price Be Your Guide When Wondering How Low Stocks Can Go


The indices (especially the DJIA) having broken down into what appears to be at least some sort of a downtrend, the key question at this point in time is how low can stocks go?

Don't Play The Prediction Game

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Understanding how corrective phases tend to function can be very helpful in dealing with the way things unfold. Although there is a long list of reasons to be bearish on the outlook for stocks these days, the real key at this stage of the game is to try and determine whether traders are dealing with a garden-variety pullback or something more sinister.

In general terms, a typical pullback in the stock market tends to last a couple weeks and winds up inflicting damage on the indices somewhere in the three percent to five percent. These types of declines tend to come out of nowhere and take place several times a year. In addition, modest corrections usually end as quickly as they started and the bulls tend to eventually continue on about their business. And frankly, trying to play this type of pullback can be tricky as there just isn't enough room to work unless you are one of the "fast money" types that is in and out of stocks several times each week.

Then there's what are called "meaningful" corrections, which tend to be much longer and more severe. In short, these are the moves that even those focused on the intermediate-term time frame will want to try to avoid. The duration tends to be longer here with the declines lasting more like a month or two and the damage being something closer to 10 percent.

The problem however, is that one never knows in advance whether there's going to be a pullback that is brief and manageable or something that makes a trader wish they'd never hit the 'buy' button. It is for this reason that traders/investors may want to let price be their guide during these types of environments.

Is Now The Time?

The vast majority of investors attempt to do the opposite and game the expectations for the outcome of the next move. So, now is the time folks. With the S&P 500 off 3.1 percent from its August 2 high, now is when those folks who like to predict what will happen next will need to make an important decision. Is this move about over? Or is it just getting started?

Most will look at the issues of the day to help them divine how low stocks can go. As was stated on Friday, there are indeed lots of reasons to be bearish right now including:

  • Current bull market is getting long in tooth
  • Unrest in Egypt/Middle East
  • Political dysfunction in Washington/Upcoming budget battle
  • Slowing earnings growth
  • Worries about second half recovery
  • The "taper" decision
  • Fear of a "policy mistake" by the Fed
  • Rising rates
  • Slowdown in China/Emerging markets
  • The state of Europe (i.e. the banks aren't fixed)
  • The calendar is not the bull's best friend for next two months

Even the most ardent bulls will need to admit that the above list of "issues" facing the market is a bit daunting. And the bottom line is this may be why the sideways trading range that had been in effect for three weeks or so suddenly morphed into a downtrend last week. As was stated on Friday, if ever there was a self-fulfilling decline, this appears to have been it.

However, it is important to keep in mind that with the possible exception of rising rates and the growing violence in Egypt, there is nothing new on this list. And remember, in the stock market, something that everyone knows isn't worth knowing!

Where Does This Leave Traders?

So, where does this leave us? Should we assume that the bears are going to remain in control and start adding some shorts via the ProShares Short S&P 500 ETF (NYSE:SH) or the UltraShort S&P 500 SDS' (NYSE:SDS) here? Or is it time to bet that this decline is closer to being over than beginning and to start nibbling at your favorite long positions?

Since the on-switch to the crystal ball refuses to cooperate these days, and as was mentioned above, this is probably a great time to let price guide positions. In sum, this is the time to forget about making a big "call" and let Ms. Market simply tell you what she wants to do next.

What does that mean, you ask? In simple terms, it means that now is a great time to watch the price action. Watch the way the market acts at the 50-day moving average on the S&P 500, which today resides at 1657. Watch the important trend lines, the support zones, your favorite short-term trend indicators, and the Fibonacci retracement levels. And perhaps most importantly, watch how the market acts when the bulls try to make a comeback. Remember, a feeble rebound attempt will likely lead to additional downside while a roaring bounce can often mark the end of a correction phase.

Finally, recall that bottoms of garden-variety pullbacks are usually "V" shaped and happen quickly. However, more meaningful corrections usually require a "bottoming process" to occur where lows are put in and then tested and retested So again, this may be an excellent time to put away the crystal ball and just let price be your guide for a while.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. Technical Levels

2. The State of Fed/Global Central Bank Policies 3. The Outlook for the U.S./Global Economy 4. The Level of Interest Rates

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Negative (Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Neutral (Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive (Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Near-Term Support Zone(s) for S&P 500: 1655
  • Near-Term Resistance Zone(s): 1680

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator: Moderately Negative
  • Price Thrust Indicator: Neutral
  • Volume Thrust Indicator: Moderately Negative
  • Breadth Thrust Indicator: Moderately Negative
  • Bull/Bear Volume Relationship: Positive
  • Technical Health of 100 Industry Groups: Moderately Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • Overbought/Oversold Condition: The S&P 500 is oversold from a short-term perspective and is moderately overbought from an intermediate-term point of view.
  • Market Sentiment: Our primary sentiment model is negative .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Neutral - This tells us to be cautious at this time.

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Turning To This Morning...

Things are fairly quiet in the early going on this summer Monday. Vacation season remains in full swing and there is no economic news on the calendar in the U.S. today or tomorrow. As such, traders will be left to their own devices. Currently U.S. futures are following Europe a bit lower and pointing to a slightly lower open.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets: - Japan: +0.79% - Hong Kong: -0.24% - Shanghai: +0.85% - London: -0.38% - Germany: -0.27% - France: -0.72% - Italy: -1.72% - Spain: -1.14%

Crude Oil Futures: -$0.40 to $107.06

Gold: +$4.70 to $1375.20

Dollar: lower against the yen, euro and pound.

10-Year Bond Yield: Currently trading at 2.852%

Stock Futures Ahead of Open in U.S. (relative to fair value): - S&P 500: -4.53 - Dow Jones Industrial Average: -25 - NASDAQ Composite: -3.11

Thought For The Day...

"The Gods cannot help those who do not seize opportunities." Confucius

Looking for Guidance in the Markets?

The Daily Decision: If you want a disciplined approach to managing stock market risk on a daily basis - Check the "Daily Decision" System. Forget the fast money and the latest, greatest option trade. Investors first need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets. The Daily Decision system was up 30.3% in 2012, is up more than 25% in 2013, and the system sports an average compound rate of return of more than 30% per year.

The Insiders Portfolio: If you are looking for a truly unique approach to stock picking - Check out The Insiders Portfolio. We buy what those who know their company's best are buying - but ONLY when they are buying heavily! P.S. The Insiders is up over 30% in 2013 and has nearly doubled the S&P 500 since 2009.

The IRA/401K Advisor: Stop ignoring your 401K! Our long-term oriented service designed for IRAs and 401Ks strives to keep accounts positioned on the right side of the markets. This is a service you really can't afford not to use.

The Top 5 Portfolio: We keep things simple here by focusing on our five favorite positions. This concentrated stock portfolio employs a rigorous custom stock selection approach to identify market leaders. Risk management strategies are built in to every position.

All StateoftheMarkets.com Premium Services include a 30-day money-back guarantee!

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Mission Statement

At StateoftheMarkets.com, our goal is to provide everything you need to be a more successful investor: The must-read headlines, market commentary, market research, stock analysis, proprietary risk management models, and most importantly actionable portfolios with live trade alerts.

Finally, we are here to help - so don't hesitate to call with questions, comments, or ideas at 1-877-440-9464.

Wishing you green screens and all the best for a great day,

David D. Moenning Founder and Chief Investment Strategist StateoftheMarkets.com

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

Positions in stocks mentioned: none

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