The Potential Depth of the Corrective Action

Markets’ darling leaders sell off? Check. Defensive sectors rotate up? Check. Seasonality coming into play(if you believe such stuff)? Check. S&P 500 VIX spiking? Not check. We have yet to see the S&P 500 really start to come down off its highs for the year just yet. Although, the market action has probably felt terrible for those heavily weighted to the NASDAQ, we have yet to see some heart-wrenching downside action in the S&P 500.

SentimentTrader just shared a note about the lack of volatility in the VIX and the downside potential in the S&P 500, “There have only been two other times in the past 20 years that the Nasdaq Composite had dropped more than -8% from its 52-week high, but the VIX “fear gauge” was still below 17.5, a scenario we have now. It shows relative complacency in the face of a sell-off in higher-beta stocks. Those two occurrences were March 28, 2002 and May 15, 2008. The S&P 500 sold off more than -15% over the next three months both times.

As usual, the statistics suffer from a small sample size within a relatively short period.

However, the facts are the facts.

Add in that earnings season has been off to a fairly weak start and you have that much more evidence to make you pause and consider before allocating more long capital right now. For any readers who are EPS hounds and swear that stocks always follow earnings, here’s a snapshot courtesy of Thompson Reuters’s Alpha Now that also supports a pause in the action through the spring and potentially summer.

S&P 500: EARNINGS AND REVENUE GROWTH TREND

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And to keep my confirmation bias fully intact, here’s a snippet from Louise Yamada courtesy of CNBC. I can’t believe I’m quoting material from the hack-shop CNBC, but Louise truly is a legend in the institutional research side of technical analysis. Anyways, she states, “I don’t think the pullback is already over. I think that it’s an interim pullback, and we’ve certainly seen what we’ve expected, in the Internet and biotechs coming off. And I think that although they may bounce, there’s probably still a little bit more to go on the downside…If we break that level(1,750 on the S&P 500), that will be the first lower low that we would have seen all the way back to 2011, really…Below 1,750, support lies at 1,650.

If we hit that 1,650ish area, then that’s approximately 10% to 12% off the highs for the year. But who’s to say we have to have a minimum 10% correction? I’ve been calling for that level of correction to clear things out a bit in the market. Many other commentaries have also focused on the need for at least a 10% correction in the S&P 500 to work off overbought levels.

Richard Dickson, Chief Market Analyst at Lowry Research, recently gave an interview at FinancialSense.com providing his outlook on the “need” for a correction of at least 10% in the S&P. If you’re unfamiliar with Lowry Research, they are one of the true OG’s in the game of institutional level technical analysis and the oldest firm in the US to provide such services. Dickson stated that:

We’ve already had two corrections well over 10% from 2010 to 2011 in this bull market and, historically, if you go back and look at the various bull markets and use the Dow Jones on a closing basis, we’ve never had more than one 10% correction in a bull market… Since 1940, we’ve never had more than one, so this has been a little unprecedented in the fact that we’ve already had two. So, to say “well, we need another one”…my response to that is we’ve already had two, how many do you want?… As things stand right now, any pullback, whether it’s 5% or 10%, in our opinion, would simply be a buying opportunity.

So there you have it. Buy the dip according to Dickson.

Still though, want some basic ideas on how to play some downside action? Buy VXX or leverage it up and buy some Calls on VXX. You can buy some Puts on the SPY or eliminate the risk of purchasing the optimal option and purchase the 3x leveraged SPXU from ProShares. It may be a little late, but utilities ETF’s such as XLU have been the home of the defensive minded for several weeks now. The typical disclaimer applies regarding your own trades.

I intended to share some thoughts and charts on the serious distortions to the financial landscape, as stated at the end of my last post. My apologies but you’ll just have to wait till the next post again, where I will definitely talk distortions. I promise. Bis spater.

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