Anatomy of a Stock Market Correction

Our belief has been that the market has been overbought and continues to be overbought. Additionally, the market has been driven up in a very calculated, and if you will, manipulated way thorough the futures markets. Regardless of our beliefs, looking at different indicators backs up our belief that a rest is needed at a minimum, if not more.

The CBOE Equity Put to Call Ratio reached .40 last week, the lowest reading since the Historic March 2000 top and July 1999 top. The VIX, which we have discussed in the last month, has become almost non existent and even ignored. Rallies to new highs were being done on 30 to 40% less volume in the NYSE. Our proprietary overbought indicator is showing the third highest historical overbought reading since March 2000 and 1998. There had not been a Trend Down day in over 6 weeks (a day where the market closes 1% lower). What was missing for a pullback was a catalyst.

Enter the SEC and their fraud charges against Goldman Sachs. This may just be the tip of the iceberg, as we can not imagine that the SEC will stop here, without putting a microscope on the other Investment Banks. The new proposed financial regulation bill is sure to be something that the Investment Banks do not like. Someone was trying to make a point – the market had just hit a new high the day before, with little volatility, and they brought these charges on Expiration Friday. The day usually has a big time increase in volatility and volume. The charges could have been put off until the weekend or after the close.

Typically, here’s how the correction goes. Once the sellers enter and attack the market, the action that follows has a very similar pattern. The bad news or catalyst catches everyone by surprise, and creates anxiety and fear in a very complacent market. The first pullback is about 30-50 S&P points down. We achieved this (1210.50-1179.75= 31 points). The pullback happens over 1 to 3 days (Check, here too!). This is the first warning that the tide is turning. Then a rally is attempted, but usually the bounce falls short of previous highs on weak action – not much energy and a slow price recovery. The following sell off is much more serious in volume, time and the amount of price decline. This pullback should knock 100 to 200 points off the S&P from the 1210 high. Due to the high level of overbought readings we think the pullback could go even further.