My main focus today is on answering the question: "Is this a regular 5% market pullback, or are we in for a deeper downside decline, perhaps a 10-15% correction?"
First, I will say that we don't have the answer yet, but we are starting to see sneaking signs of an oversold bounce.
Whenever the market begins to pull back from the highs - particularly in a violent method, like it has done in the past week, my goal is always the same: to answer that question I asked above.
To do this, I look at three key factors. These are the main signals I use to identify opportunities for buying on the dip. If these conditions aren’t met, then that is when I know I’m looking for a steeper decline, and I should prepare my portfolio accordingly.
I look for:
1. Support in the Indexes
When quantifying the behavior of the indexes, I always start with the Nasdaq and the S&P. Why? The behavior of these two are particularly important, as these indexes are the leading indexes in the market, and as such, they have the capability to lead the market higher or lower. Sometimes traders will focus on the Dow or the Russell to quantify the strength or weakness of the market, but for me this is a mistake. Why? It’s because these indexes have been lagging all year. When they fall, they fall first, and when they rise, they rise slower and weaker than the Nasdaq and the S&P. For that reason, they aren’t great quantifiers of market health for me.
What Do I Look for?
I look for a hold of support on the daily time frame that is a combination of key moving averages and Fibonacci clusters or symmetry. I like to identify an overlapping area, to find a strong level of support. I also like this hold of support to show up when the market is oversold.
In a healthy pullback in a strong market, I use the 34 EMA on the daily chart, or the 50 SMA on the daily. In a deeper market pullback, such as the one that has occurred after the most recent trader war escalation, I use the 200 SMA as my deeper zone. By overlapping this area with symmetry from the previous corrective swings, I’m able to determine where there is support.
A hold of this support is indicative of a good time to look to buy the dip. A break of this support is indicative of a much further decline. Oftentimes, the indexes will break the first level of support around the 34 EMA and the 50 SMA, but hold the lower one on a deeper pullback.
Nasdaq Futures - Daily Chart
Currently, the S&P is holding the 200 SMA and the Nasdaq is holding it as well. I also like this to occur when the indexes are oversold, indicating we are close to a bottom. This is my first sign it may be time to buy the dip.
However, a hold of support with an oversold condition is just one factor. Let’s talk about the next two.
2. Signs of Life in Market Leaders
The Nasdaq holds many of my favorite market leaders, including MSFT, ADBE, FB, and NFLX. These stocks are typically the first to go positive after a correction in the indexes. I look for these stocks to turn positive, along with the hold of the lows, that comes with consistent buying to the upside. These market leaders lead the way. Once there is confidence for investors to come back into these strong, leading names, buying ticks up, and the leaders pull the market higher. So far, we are seeing several of these names in the green, but they are still teetering.
MSFT Daily Chart
This image was taken on August 6th, 2019. This was a day where the indexes as a whole were teetering between positive and negative on the day. However, Microsoft maintained a decent bid, up almost 1%, and it was right near key support. This signaled to be that it could be the start of ‘buy the dip.’
3. Bias Slant in the Market
Often times, what happens when the market experiences a sharp sell off, is that the market gets lopsided. The same situation occurs when the market is incredibly strong, and continues to make new highs.
In a sell off, for example, what will happen is that options traders are loading up on far more puts than calls, which is signaling that the primary sentiment is bearish. When ‘everyone’ is bearish, there is nobody left to continue selling and pushing stocks lower. In order to ebb and flow, the market needs balance. A high put/call ratio signals that too many are bearish, and the market is not balanced.
This sets up a situation for a short squeeze. What is that? It’s when the market trades higher, and shorts are forced to cover their positions in mass - this buying pushes equity prices higher.
This always happens when there is some sort of positive news catalyst that will cause an overnight gap up, and all of those shorts begin covering at the same time. They see red at market open, and begin closing in masse. This, in combination with new buyers coming into the market, will send the market pushing higher, and result in a short squeeze.
Nasdaq Daily Chart in Comparison with the Put/Call Ratio
On this chart, I’ve highlighted the put/call ratio, in comparison with Nasdaq futures on the daily chart. What you’ll notice is that when the green bars spike up above the 1.20 level, this is signaling that the market is slanted, and too many traders are short - to the extreme. You’ll see that this situation normally coincides with a low, after a steep sell-off.
I look for a high put/call ratio to tell me a short squeeze rally is possible, but it never tells me when the rally higher will occur. It just sets the stage. What the market needs for the actual short squeeze is typically a hold of support and an oversold condition, market leaders to show signs of life, and a high put/call ratio. It’s the news catalyst that results in an overnight gap up, that typically begins the squeeze.
We saw this in February of 2018, again in April 2018, a higher low in July 2018, on December 26th, 2019 after Mnuchin’s comments (one of the strongest days in the market in over 10 years I believe), again after the selloff in May 2019 and we are seeing it right now.
Everyone will tell you - it’s impossible to call the exact high or the exact low. But you can get close, and this is how I do it.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.