The latest pullback in the markets may have you a little
spooked, especially if you own small cap stocks (NYSEARCA:IWM)
which are down almost 5% already in July. Year-to-date
(YTD) small cap stocks (NYSEARCA:TZA) have also significantly
underperformed, now flat for the year.
Is this just another short-term relief selloff that should be
bought, or is a larger pullback brewing?
First, it's important to recognize no large selloff has occurred
without some sort of cracks forming in the markets' shorter term
foundations first. The short-term always breaks before the
Chad Karnes gives his mid-year update on the Index
Even the Monday, October 19, 1987 20.5% one day crash saw its
previous three days already down a combined 10% as the month of
October before the crash was already down 15%. The 1987 crash
sent the entire October peak to trough move down over 35%.
There was plenty of warning something negative was brewing,
especially if technical analysis was being utilized.
Because of such risks there is always reason to keep an eye on
what is going on in the short term, even if a 5% or even 10%
pullback is acceptable for longer term investors. Such
pullbacks can quickly turn into larger corrections, and that is
always a risk.
There is no shortage of similarities between current market
conditions and those just before other price peaks (1987
included). Many of these similarities we have pointed out to
our subscribers, and they range from technical readings,
statistical anomalies, fundamentals, or extremes in sentiment.
What's important, though, is none of these similarities matter,
not until the market changes its course from up to down.
These similarities to all the other major market tops thus far
haven't reversed the market.
Price is what investors should ultimately care about, and that's
why we focus on key technical levels to keep us ahead of price
Check out the first chart below showing the the S&P
500′s performance (NYSEARCA:SPY) just before the 1987
crash. Notice that trendlines helped warn when price momentum
and thus the trend was ending?
Utilizing trendlines would have helped even the longest term
investors get out before the bottom. Others keeping an eye on
the shorter terms would have avoided the 20% crash altogether as
they heeded the market's warnings in early October.
A similar trendline strategy also warned of the 2000, 2007, and
2011 market tops.
Combining Trendlines with Indicators
Now check out the following chart similar to one I have provided
our subscribers that shows the S&P (Nasdaq:VFINX) since 1990
overlaid with a popular momentum indicator.
Notice anything similar occurring today that also occurred at
the recent major market peaks?
The red arrows show that the previous major market peaks
occurred only after RSI reached overbought territory above 70%.
Today, the market has again reached these levels (shown by the
red circle), but that doesn't necessarily mean it's time to
sell. As can be seen in the graph, the late 90's taught us
that price can stay overbought and extreme for as long as a few
years. 2007's occurrence on the other hand provided a quicker
end to the rally.
Currently, we are somewhere in between the two, overbought
on a monthly basis, something that has accompanied every other
major market peak.
As a result, the focus should be on preserving existing gains
from the rally, instead of buying on the dip
2011 versus 2014 - What to Watch
The following charts were also recently provided to our
subscribers through our twice weekly published Technical Forecast
and show a similarity between today's market and that leading up to
the more recent 2011 20% pullback.
Following up on an article found on our home page,
'Dow Hits Key Milestone, Despite Slowing
, the Dow (NYSEARCA:DIA) has risen 6,300+ points off its
October 2011 low, but it has struggled of late, similar to what
occurred during the 6,300 point move from the October 2009 low to
the 2011 price high.
More importantly, once the 2011 price high was made, a break of
a similar trendline strategy as shown in the 1987 example warned
that the markets' trend had changed and risks were increased for
That slope trendline and breakdown in May 2011 is shown on the
chart below. Following its suggestion, investors saved over
15% of losses suffered the Summer of 2011 as the markets in
classical technical fashion backtested the broken trendline in
July, providing one last exit opportunity.
I am watching for a similar breakdown in the Dow's trendline off
of the 2011 lows to warn of the next big market pullback.
This is shown in the final chart below.
In addition to the trend similarities, the long term overbought
reading shown in the S&P chart suggests the downside risk of
such a break is also likely more than the 20% that occurred in
2011. 2011's price never entered overbought territory like
the year 2000 or 2007.
We already know that technically the market is long term
overbought, just as it was at all the other major market
peaks. We also know, as we have pointed out to our
subscribers in a plethora of examples, that sentiment (NYSERCA:VXX)
is historically bullish, also something that typically accompanies
Fundamentals also aren't supporting the markets continued rise
as GDP prints its largest negative reading since the 2009 recession
and 2014 estimates are now again at under 2% growth (from a
previously expected 4%+). Retailers (NYSEARCA:XRT) are also
now finally admitting that 1Q's slowdown was not weather related as
sales rebounds have not occurred as expected.
All that is missing from the bearish puzzle is the technical
price breakdown. Once that occurs the risks greatly increase
the market's (SNP:^GSPC) pullback will be of the larger variety as
suggested by the fundamental, sentiment, and technical extremes
Profit Strategy Newsletter
follows all the major asset classes with a focus on technical,
sentiment, and fundamental analysis. We offer actionable
trade setups individual investors can utilize through ETFs.
Once the "bull/bear" trendline I have been following breaks down,
it will be a major warning sign the markets may finally be ready to
start their long awaited 20%+ pullback.
Follow us on Twitter