A Correction in the Market

Well it appears we have finally entered a correction in the market.

As is so often the case in these situations, one months’ work is erased in a matter of days. And buyers of the past month are left scratching their head and licking their wounds.

As I mentioned to Daily Reckoning readers on the 21st of October:

“The risk of entering the markets at this time is very high. Any longs should have tight stops, but any shorts need to wait until short term momentum indicators have shifted into negative territory which they haven’t as I have stated in the past. Could be a good idea to take a bit of money off the table if you are sitting on good profits from the past few months. When the music stops you will only get a chance to sell with everyone else and it will be at much lower levels in the blink of an eye.”

Well the eye blinked and we are 250 points or 5% lower than we were on the day of the note one week ago.

Now that we’ve entered a possible correction the inevitable questions pop up.

“How much further will it go?”, “Should I be waiting to buy once the corrections over, and when do I know it’s over?” and “Should I short sell here?”

Well, let’s be honest, if I knew the precise answer to all of those questions I’d be snorkelling in the Bahamas with Scarlett Johansson.

But what I can do is give you an educated guess based on my 16 years in the markets.

In this article I’ll look at where we’re going from here and where the good risk reward opportunities are.

The first thing to consider is the US Dollar index. I placed a comment in yesterday’s Daily Reckoning about the link between the US dollar and the commodity and stock markets.

The dollar is being used for the carry trade by all of those poor banks that need to receive free money from the Fed Reserve so they can speculate on everything from US bonds to stock and commodity markets to repair their balance sheets (Can I have some?)

It is this distortion in interest rates that I believe has lead to this ridiculous 60% rally from the lows that has happened at an unprecedented pace.

Look back at the Chinese stock market this year when they went into a parabolic rally.

As soon as the government sensibly came out and said they were going to rein in some of the not so sensible liquidity the market dropped 20% in a flash.

We don’t have to worry about that here because Federal Reserve chairman Ben Bernanke knows he’s not allowed to stop the party. He’ll do a Greenspan and pump it up until he has to retire and leave the mess with some other schmuk.

It’s like the world’s biggest game of pass the parcel. The only problem is the present at the end isn’t a toy giraffe. It’s something a lot smellier than that!

So with one eye on the US Dollar we can turn to the Aussie market and ask ourselves a few questions.

Have a look at this chart:

My favourite moving average crossover to use is the 10 day/35 day. Look back over this whole period and see how accurate it has been in letting us know whether we are in up or down trend.

There was only one small period in July where it sent a false change of trend signal, but apart from that if you only entered positions in line with its direction you would have done very well.

This indicator is telling us that even though we have dropped 5% in the past week, we are still actually in an uptrend. This may soon change however, but pre-empting your signal is a bit self defeating. There would have been many times in the past where you could have thought the trend was about to change but it didn’t so patience is still called for.

Now let’s have a closer look at this chart and get an idea of what lies around the corner.

The range between the 2 blue lines is from 4779 reached on the 29th September to 4542 reached on 5th October.

This range will be very important to the next price action to come. The market will often create a distribution around a point of control while the market whips traders out of positions and then finally goes in a certain direction once most traders are fatigued.

Even trends can be seen to be progressively higher distributions of price if you look close enough. If we were to see a distribution around this initial range then the point of control would be the midpoint of this range (4660) and since we have had such an impulsive rally over the past few months, there is a high probability that some sort of distribution in price will be formed up here before we finally fall over into a more sustained correction.

Therefore if we want to trade this correction, we have to wait for the distribution to form and wait for the good risk/reward opportunities. Also if we are bullish and want to find a good buying point, then we have to wait for the false breaks of the bottom of this distribution before we can be confident of a good entry point.

Now having said all that – and hopefully your eyes haven’t glazed over yet, have a look at the chart again and look at that low of 4542.

Now that we’ve broken through the midpoint at 4660 we can safely say that 4542 will be tested and probably broken (It seems to be getting pretty close as I’m writing). My best guess is that a false break of that level will occur and whip out any shorts that try to sell this break thinking it’s the change of trend.

The size of the false break (ie. How far the market sells off through this point before bouncing) is usually contained to the dotted blue line beneath the range (4430) which is 50% of the range mentioned above.

Therefore I believe that we’ll see a sell off that will be contained between 4450 and 4550 and then we will see a short squeeze from there which could head back to the point of control.

From there the market could either break back through the point of control and then head for another leg up. Or it could find resistance there and retest the lows. In which case you’d expect to see a much larger sell off.

So for the bulls I would say to buy stocks that you want to own between 4450 and 4550 with an initial target on the All Ordinaries back to the point of control where you would take half profits with a stop loss on your positions if the market trades below say 4300-4350.

And for the bears you should be patient and wait for the short squeeze back to the point of control before entering shorts. And also wait for the confirmation of the crossover of the 10day/35 day moving average.

Whatever you do, don’t freak out and try and join in the fun because you feel like you’re going to miss out. Patience is your friend.

Fear of missing out is a quick road to the poor house.

Murray Dawes
Technical Analyst

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