2 types of corrections

Just as quickly as the Semiconductor
Index
(
SOX |
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dragging the Nasdaq
(
COMP |
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Nasdaq Composite and small-cap Russell 2000 Index fell 1% yesterday, giving back
all of the previous day’s gains and then some. The S&P Midcap 400 continued to
show relative weakness with a 0.8% decline, while the S&P 500
(
SPX |
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Jones Industrials
(
DJX |
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PowerRating) lost 0.4% and 0.2% respectively. Despite the losses,
many stocks recovered off their lows in the afternoon, but selling pressure in
the final thirty minutes caused the major indices to finish in the middle of
their intraday ranges.

Total volume in the NYSE declined by 8% yesterday, while
volume in the Nasdaq was 10% lighter than the previous day’s level. Given that
most of the down days in the market over the past two weeks have been on higher
volume, it was a positive that turnover declined yesterday. However, the
previous session’s “accumulation day” has now been invalidated because the broad
market wiped out all of its prior day’s gains. Even though volume declined in
both exchanges, bearish market internals confirmed yesterday’s losses. In both
exchanges, declining volume exceeded advancing volume by a margin of 3.3 to 1.

If you have been watching the action in the semiconductor
sector over the past two days, you may have acquired a good feeling for just how
weak the market really is right now. After failing to break out above resistance
on May 5, the $SOX fell victim to a nine-day losing streak before finding any
buying interest. Finally, the index rallied more than 3% on May 19, recovering
its losses of the three prior days in the process. When such a swift retracement
takes place, an index usually will at least linger in that range for a few days,
or even attempt to move a bit higher, before resuming the direction of its
trend. But such was not the case for the $SOX. Instead, sellers aggressively
attacked the semiconductor stocks when the market opened yesterday, causing the
$SOX to surrender its prior day’s gain within the first hour of trading. By
day’s end, the $SOX had closed at a new six-month low. Looking at the daily
chart below, notice how the $SOX was so weak that it completely ignored support
of its 200-day moving average on May 12:

As you might have guessed, such action as described above
indicates a market that is in a very strong trend. Unfortunately, strong trends
often present a bittersweet dilemma. The positive of a strong market trend
(either up or down) is that quality trade setups have a much better
change of succeeding at generating solid profits. The negative, however, is that
strong trends often do not provide us with low-risk entry points that come from
waiting for a price retracement. In the case of strong downtrends, they often
collapse so fast that you can easily miss the boat if you failed to short the
initial (and riskier) break of support. Conversely, strong uptrends often surge
higher without providing a significant pullback for a lower risk entry point.

When trends are strong and price retracements are minimal
and/or very short-lived, there is a basic strategy that will still provide you
with the opportunity for profits, but without the risk that comes from being a
“late to the party Charlie” and chasing the big moves that already occurred. The
first thing you must remember is that market corrections always happen in one of
two ways: a correction by price or a correction by time.

A correction by price, more commonly known as a “pullback” or
“retracement,” occurs when a stock or index reverses against the direction of
its primary trend until it hits some sort of resistance or support level,
depending on whether in a downtrend or uptrend. In a steadily downtrending
market, such as the one we are in now, retracements up to resistance of both the
20 and 40-period moving averages on the hourly charts often provide ideal entry
points for new short positions. A very weak stock or ETF will often retrace only
up to the 20-MA and then resume the downtrend, while an ETF with a bit more
strength might make it all the way up to the slower 40-MA. One recent example of
such a correction by price is the iShares Russell 2000 Index
(
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sold short when it rallied into resistance of its 20-MA on the hourly chart on
May 16 and covered for nearly a 4% gain three days later:

Looking at the hourly chart above, notice how the first time
IWM ran into its 20-MA since the selloff began was on May 16, the same day we
sold it short. Since then, notice how that 20-MA has perfectly acted as
resistance that ensured a continuation of the downtrend. Each bounce into the
20-MA that you see circled above is a good example of a short-term correction by
price.

When a stock or index is showing absolutely no signs of buying
interest, it will still correct from a large selloff, but it will often have a
correction by time instead. This simply means that, rather than retracing a
portion of the trend, it will trade sideways, near the bottom (or top) of the
range. A good example of this can be found on the daily chart of the Oil Service
HOLDR
(
OIH |
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On the circled portion of the chart, notice how OIH came down
to its 50-day moving average, but failed to bounce off that support level.
Instead, it “corrected by time” for two short days and then broke down to new
lows. When this occurs, you can enter a new short position on a break out of the
range. In this case, you could have shorted OIH when it fell below the lows of
both May 15 and 16. When the lows also converge with a pivotal moving average
such as the 50-MA, it further increases the odds of a successful trade. We
didn’t short OIH when this occurred, but we did realize a very substantial
profit from a short position in the S&P Select Energy SPDR
(
XLE |
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PowerRating), which had
a similar chart pattern.

Having a basic understanding of the ways in which markets
correct will prevent you from being “late to the party” and selling short at the
bottom of a selloff or buying at the top of a breakout. In the current
environment, you merely need to find the stocks and ETFs that have settled into
steady downtrends, then wait patiently for either a “correction by price” into a
resistance level or a “correction by time” so that you can short a breakdown to
new lows. If the security has so much relative weakness that a “correction by
time” is the only correction you get, it is advisable to reduce your position
size in order to compensate for the slightly increased risk of not getting the
most ideal entry point. At present, we are stalking a handful of stocks and ETFs
for new short entries, but they need to correct in one of the ways. When they
do, we’ll be ready. But until that happens, we will wait patiently on the
sidelines because being in cash is much better than attempting to go long any
bounces in a very weak market.

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