Playing the Correction in July - Cook`s Kitchen

Lots of smart money managers and chartists say that the market is in "correction mode." And many have strong -- and wrong -- ideas about what's driving it, where it's going, and how it will all end.

I'll grant they are right about the current market mode, even if they don't really understand what's driving it. I think I understood pretty well in late May after the market blow-off top to 1687, and I made a video on May 30 with these ideas: 3 Arguments for a June Swoon .

Most prognosticators who try to tell you how to play the correction seem like they are talking their "wish list" instead of doing objective analysis. While I can't tell you with 100% or even 75% certainty where the market is going this summer, or how and when the correction will end, I can tell you how to play it most of the time.

How? With a map, an allocation plan, and some discipline. Every few weeks, I update what I call my "Scenarios & Probabilities Market Map."

Map is Not the Territory, But It's Better Then Flying Blind

This short-term map is based on my analysis of the "Market State & Prognosis" and becomes a "field guide" to potential price action for the next 3 to 4 weeks. While I may be bullish on the longer-term, the map helps me develop my "Strategy & Positioning" for this shorter time horizon for my Market Timer trading service.

Here was the one I made on Sunday afternoon June 23 as I prepared Market Timer members for the week ahead, on the heels of an FOMC meeting that took the S&P 500 down 75 points (4.5%) in 3 days...

What did we do with this map? On Monday, we jumped in and bought the market below 1570 using leveraged ETFs on the S&P 500 and the Russell 2000. These buys took the Market Timer portfolio from 20% net long equity exposure to 55%.

While there was plenty of fear to go around with talk of the market crashing down below the support band at 1540-60 and the VIX spiking above 21, we followed our high-probability plan.

And we were able to take some profits after a 2-day rally back above 1600, retaining a 33% net long position. This is at the bottom of our "caution" range of equity allocation as I am still following my map that says the market will have a hard time getting back through S&P 1635 ahead of earnings season.

But Is the Correction Really Over?

One of my favorite ways to evaluate whether or not a corrective phase is over is by looking at past rallies, tops, and corrections. Let me be clear: even if the lows are in at 1560 for the remainder of the year (only a 50/50 bet in my mind right now), the summer is still poised to be a sideways affair as I said in my May video.

Here is one simple way of comparing the "internal composition" of corrections: the percentage of S&P 500 stocks above their 200-day moving average. I am just showing the past 15 months to make the chart more viewable as you observe what happened in the last two corrections (of greater than 5%), both in 2012.

The recent dip in the percentage of SPX stocks above their 200-day MA is barely a blip compared to the two prior corrections, where the 60% level was penetrated. And for an even bigger frame of reference, what you don't see on this chart is the 2011 correction of nearly 20% which took this indicator down to sub-10%!

Parabolic Rallies & Perpetual Tops

One of the videos I made in February took a look at Parabolic Rallies & Perpetual Tops because I wanted to see how the rally of 2013 compared to past steady surges -- and also, how they ended. I was a bull before my research and I remained one afterwards.

The video is really worth watching again to see how I use past market behavior and awareness of institutional behavior to gauge rallies, tops, and corrections. I also feature the "buying stampedes" analysis of Jeff Saut, veteran market strategist at Raymond James who has been trying to call the top in this market all year.

The other element I note in those 330 point S&P "parabolic rallies" in 2006-07 and 2010-11 was that their biggest corrections were only 6.8% for each. And that was in the middle of 25-30% rallies.

Well we just trimmed about 7% from the top depending on whether you use the high of 1687 (7.5% from there to 1560) or the closing high of the beast at 1669 (6.5% from there).

But, remember, my analysis of those parabolic rallies found their corrections in the middle to late stages BEFORE they achieved their 25-30% zeniths. Our rally off the November lows already nailed 330+ points and 25% (I know, the similarities are uncanny).

Map the Odds & Pick Your Spots, Weight the Positions & Follow Your Plan

Now before you think that I am always really accurate with my "Scenarios & Probabilities" maps, let's have some transparency here. Sometimes my map is skewed too far in one direction or the other.

But I'm fearless about being wrong there. I think it's far better to have a plan that is biased -- or just plain wrong -- than no plan at all. Without a plan, you are already a sitting duck for the market pros who count on you acting emotionally.

The truth is that my maps are always subjective, a mix of all my experience, observations, and indicators simplified down to one simple tool that let's me clearly see and engage the market. It's just a decision-making guide to frame my analysis and goals, especially during big, emotional price moves (up or down).

More often than not, my biggest mistakes are in being too cautious (or greedy) and not executing at my price zones, according to the plan I laid out. Here's a recent mea culpa video where I show how well (and poorly) I followed my plan from June 2...

Trading Maps & Plans: Build, Then Follow

But I Asked You If the Correction Is Over

I know, I haven't really answered that yet. As you might guess, it's never a simple "yes" or "no" for me because I don't pretend to predict with a crystal ball.

And even if I feel strongly one way or the other, I still don't go all-in on my full house when I see a 60% chance the card player across from me is working a straight flush (well, I might there since it's just my mind against his and the deck, not me against the whole market).

I'm trying to show you a slice of my process and methods. If you want to see more examples and details, grab a trial of my service where we just banked a big winner being short gold from above $1450 and are currently enjoying being short the Japanese yen.

Bottom line: My June 23 map still stands for the next 2-3 weeks. It's worked for a week and I expect it to continue to provide a useful field guide into earnings season. Another simple way of translating my map is this: 1550 Before 1650.

This means I see a stronger likelihood of the market going to 1550 before it crosses 1650. But that would quickly change with a close above 1630-35.

Institutional selling has been an under-the-radar feature of the past few months as shown by the McClellan Summation Index, an oscillator which totals and smoothes out movement in NYSE advance-decline statistics.

Then, just when it looked like the bears picked up the ball and were going to march 90 yards to the bulls' endzone, they fumbled. Let's call 1550 the 50-yard line (it's also the 50% retracement of the move from 1425 to 1675 so that's pretty cool), and that means the bulls are still in charge.

But the bears are licking their chops as they continue to short below the 20/50-day moving average bearish cross at SPX 1620.

So as far as the fate of the correction goes, I would say there is a good chance (60%) of more downside work to do. It fits with my "June Swoon" and "summer sideways siesta" thesis: Fed-induced bond market jitters, big equity gains since November, and summer vacation plans going into earnings season are not the ingredients for new highs after a 10% first half gain.

I could be wrong. And I'm fine with that. I not betting heavily on either direction right now. I'm still waiting for a big, fat pitch. That could come with a retest of the June lows near 1575. Or a full correction drop to 1525. Or, a surge through 1650, followed by one more pullback to buy with both hands.

Whatever comes in the third quarter, I'm ready and I can hardly wait.

Kevin Cook is a Senior Stock Strategist with

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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