A rough start to the week for the markets as we are down 1%+ in the first couple hours of the day with all three major indexes crashed through their 50dma. The S&P500 and Dow are still trading in their recent consolidation areas but the NASDAQ broke support and is making a new relative low. This continues the trend of under-performance by the NASDAQ and demonstrates weakness by technology and smaller, growth companies. Given the huge run-up and out-performance by the NASDAQ in Q1, profit taking and rotation out of this sector should not come as a surprise.
Traders watch moving averages and trade off of them, but are secondary in psychological impact when compared to technical levels represented by concentrations of actual buying and selling activity. It is one thing to see your stock fall under a moving average on volume, but seeing your stock fall under its purchase price generates far more anxiety. This causes breaks under support to be far more powerful than drops under moving averages. The NASDAQ broke under its support, but the other two indexes are holding up for the time being. A break by those over the next couple days could signal this correction still has room on the downside.
It is not uncommon to see the markets retrace ~33% to ~66% of a move as part of a normal and healthy correction. This is just part of the natural two-steps forward, one-step back process the markets use on their march higher. On the S&P500 this gives us a pullback range of 1347-1275 if we use the Dec dip as the start of the current move, or 1321-1222 if we use the Oct low.
No matter what metric we use, we still have a little more to go to make this a normal and healthy correction. As for how to trade this, we should continue to sit tight and wait for the upside confirmation before buying back in. As for using this weakness to initiate short positions, I’m not sure this down-leg will produce the profit potential necessary to justify the risk. As opposed to bear market conditions that make for the best shorting opportunities, this appears to simply be a normal pullback from overbought conditions. No doubt money could be made on the short side, but you need to be very nimble with your short trades and take profits early and often because this downward move doesn’t appear like it will cover a lot of ground. Rather than look for shorts, I think the smart move is searching for buy candidates holding up well in this sell-off so you are ready for the rebound. But of course markets top when everything looks good so we always need to be wary of what we least expect.
Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.