Recent market activity could be prelude to a larger correction
Since bottoming in mid-March, major stock market indices have staged a prolonged rally. The length and steepness of this advance caught many market watchers by surprise, because there was nothing to indicate this was anything more than a typical bear market rally. That perception was reinforced in June when markets posted a loss and technical indicators turned negative. But stocks were able to turn around and resume their climb.
At present, technical indicators are again signaling that stocks could be on the brink of a more significant downturn. It is too early to tell how long or severe this correction will be, but the next couple of weeks could give a clue about what to expect for the remainder of the year.
The chart below shows price performance of the S&P 500 over the past year. Notice how the black line on the chart is rolling over and looking very similar to what occurred in June. The gold line is a 50-day moving average and the index could break below that mark with another day or two of negative market action. If it breaks below that technical support, investors holding long position should consider selling or hedging.
Even if the index breaks its 50-day MA, that does not necessarily mean a significant correction will follow. At the beginning of July the index broke decisively below its 50-day MA only to reverse itself after a few days and climb back above that mark. In hindsight, that signaled a good buying opportunity. But just four months after a 50% correction jumping back in at that point still seemed like a high risk move.
That gives us something to watch for this time. There is strong support at about the 1,000 level. That would be slightly below the 50-day MA. A reversal from that point would probably prompt a buy signal as the index crossed back above its 50-day MA. If the S&P 500 continues to fall below 1,000, we could see a correction lasting several weeks.
The bottom portion of this chart is a relative strength index (RSI). The RSI has already dropped to the 50 level. If this indicator continues to fall it would be a strong indicator of growing market weakness.
The middle portion of the chart is a moving average convergence divergence (MACD). This indicator is still at an overbought level. That means that although the S&P 500 has already had several down days, there is still plenty of downward pressure that could cause it to fall even more.
The next couple of weeks could prove to be important. Some of the biggest down days ever experienced by stocks have occurred in October. Given the current weak economic fundamentals, it would not be unprecedented to see a sharp drop in stock prices. On the other had, stocks could rally again and keep the current upward trend intact. In that case, we should be prepared to take advantage of any investment opportunities.
F.S.
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