Investors breathed a BIG sigh of relief Monday as the stock market bounced off of oversold conditions and posted its largest one-day point gain – ever. The S&P 500 jumped 4.6% higher, recovering 136 points of last week’s brutal decline.
The rally was forceful enough to cause a lot of the financial television talking heads to suggest the correction is over. Friday’s low of 2850 on the S&P was the worst of it. They say stocks are now ready to rally again.
I’m not so sure.
You see typical stock market corrections unfold in three distinct legs.
The next leg is an oversold bounce. This move forces short-sellers to buy back their short positions – often at a loss, especially if they got too aggressive and sold short into oversold conditions. Meanwhile, the bulls scramble to get back in and they chase prices higher. That’s where we are now.
The third leg of a correction is a move back down to retest the lows of the first leg. It’s usually a fast and uncomfortable move that gets the bulls to finally cry “uncle.”
I suspect we’ll get to that leg either later this week or early next week. Let me show you what I mean…
The following chart shows two correction phases the S&P 500 went through in 2018…
The first leg of the first correction started in early October. The S&P 500 lost 7% (the first “1” on the above chart) before it got an oversold bounce. The bounce pushed the index back up to its 9-day exponential moving average (EMA – the thin red line on the chart) – which is a logical resistance level and halted the second leg (the first “2”). Then, we got the third leg of the correction (the first “3”) – which, in this case, took out the previous low.
The first leg of the second correction (the second “1”) started in December. The S&P 500 lost 16% by the time that leg ended. The oversold bounce that kicked off the second leg (the second “2”) was strong enough to rally the S&P back up to its 9-day EMA. The index then pulled back from there with an abbreviated third leg move lower (the second “3”).
These are two good examples of how market corrections typically unfold.
So now, let’s take a look at the current situation…
The first leg of the correction ended on Friday (point 1). On Monday, we got an oversold bounce – which continued on Tuesday morning when the S&P tagged its 9-day EMA.
Just like in previous correction phases, the market found resistance at the 9-day EMA and turned lower. This likely marked the start of the third leg of the correction. (I’ve drawn in a blue dashed line to show how this may play out.)
But my point is that I don’t think stocks are just going to keep on moving higher from here. The market has more work to do on the downside.
Best regards and good trading,
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