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
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 is going to be a pullback that is brief and manageable or something that makes a trader wish they had 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 the 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.
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 (SH) or the UltraShort S&P 500 SDS' (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.