Three weeks ago, we asked whether the bearish arguments about the market’s pending demise were correct. Sellers have some good points — valuations are high, growth is low and the yield curve is flattening. However, we argue that while the bears will eventually be right, a bear market is very unlikely to appear for a while.
We continue to stand by the opinion that the market is not at risk for any major declines.
That estimate, however, doesn’t change the potential for short-term corrections (-3% to -7%), but, again, we expect them to be short-lived. It’s possible that the market is experiencing such a correction now, which means that the right course of action is to target some very-short-term bearish trades and prepare to jump into some bullish positions when support comes into play.
Which Stocks Do Worst in a Drawdown?
If the market is correcting, sellers will tend to target companies that are struggling fundamentally due to new competition or declining sales/margins.
Some sectors might “outperform” to the downside, but it’s more reliable to pick the biggest losers on a stock-by-stock basis, with a focus on fundamentals.
Which Stocks Do Best at the Bounce?
It is typical for finance, tech and retail to lead bounces off of support. This tends to be true for small corrections as well as longer-term business cycles that last for several months. This can be helpful in refining our technical analysis to identify the bottom.
The last bounce/breakout started near Sept. 10 and, if the market draws down over the next several sessions, we would expect September’s pattern to repeat itself. A focus on the leading sectors will help time the rally because the major stock indexes haven’t been drawing down far enough to affirmatively identify support signals.
For example, as you can see in the chart below, the Financial Select Sector SPDR Fund (NYSEARCA:XLF) formed a classic bullish “harami” pattern at a long-term pivot level near $23.85 that was confirmed on Sept. 11 with a higher close.
Support or breakout signals on the major indexes were much more abbreviated and ambiguous at the time.
Financial Select Sector SPDR Fund (XLF)
Because the market’s “cycles” are fairly regular, this helps to give us a technical framework for emerging bullish momentum if the major indexes themselves are more ambiguous. We are watching the same major sectors/groups for signs of strength if this drawdown continues. For example, the $25.35 pivot level on XLF could be the next inflection point for a bullish rally.
Chances are good that a signal in one of the “early” sectors will be the best leading indicator this time around as well.
The Bottom Line
Concerns for tax-reform prospects are probably weighing on traders. The “sell-the-news” phenomenon could lead to additional short-term declines regardless whether Congress’ prospects for tax cuts improve or decline from here. Fortunately, dip-buying opportunities tend to be the most productive for profits, so a temporary decline is likely to be the first step to a very profitable few weeks.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.