Has The Long Awaited Correction Arrived?

Since late November 2010 we’ve been waiting for a correction while the market managed to shrug off every single sentiment and technical indicator that suggested this. Those following sentiment data have been especially frustrated since we’ve seen some very ebullient survey data these past few months. While several indicators have been flashing red for some time, it was just last week when the Investors Intelligence survey reached the critical 3:1 bear to bull ratio. But other indicators such as the (equity only) CBOE put call ratio were stretched to the max and the ISE sentiment index broke new record levels of bullish call buying relative to put buying.

As I mentioned a few times, the market reacts differently to sentiment indicators depending on the nature of the market. Since it has just been a little while that we’ve exited a bear market, many expect the usual sentiment surveys like the AAII survey of US retail investors to behave the same way that they did in 2007 and 2008. But since we are in a bull market, it takes more time for extremely bullish sentiment to finally seep into the market and cause its natural consequence.

We’re starting to see some rolling over in the underlying structure of the market. Earlier this week I mentioned the New High Low index from Dr. Elder and commented that the weakness of this indicator is that it isn’t relative. This makes it difficult to compare across time spans with confidence. There is another similar indicator which is relative, called the High-Low Index.

This indicator takes the number of new 52 week highs and divides it by the number of new 52 week highs plus new 52 week lows. The current indicator for the Nasdaq Composite has fallen sharply this week in reaction to the market weakness:

In a bull market, we usually we see a correction play itself out with this indicator falling to 20 or lower. In a bear market, it can easily go much lower and stay there for a prolonged period of time. This indicator is available at StockCharts with the symbol $RHCOMPQ.

As well, the 20 day average of the Nasdaq Advance Decline (daily issues not cumulative) has also rolled over after topping out in December 2010:

The Nasdaq Summation Index (ratio adjusted) is showing basically the same thing. While the shorter term breadth indicator, the McClellan Oscillator (ratio adjusted) has already fallen rather precipitously and after a few down days, it will no doubt be close to reaching an extreme low.

The S&P 500 index only managed to break the 30 day streak of positivity with a 1% decline on Wednesday January 19th 2011. But in the overall scheme of things, this is a trifle. We’ve become so used to seeing only green on our screens that a moderate profit taking day appears bigger than it is. But in reality, a correction of 10% would only be natural and healthy. And it would mean a retracement from (appx.) 1300 on the S&P 500 index to 1166. That would be near the November 2010 lows which will be acting as support now.

Remember, the April 2010 high to July 2010 low was a 17% decline. So a 10% correction, as is expected by Lowry Research, would be moderate. And based on the longer term breadth data such as the percentage of stocks above their long term averages or the cumulative advance decline line of the S&P 500 index, the health of the bull market is still intact for an eventual return to these highs.

Finally, when we consider the heady heights the market has climbed from the low in March 2009, such a correction would be a vital necessity in order to clear out some of the weak hands and set the foundation for further gains. Consider that over the 22 months – the duration of this cyclical bull market – the S&P 500 has climbed 91.42%. Within a historical context, that is a meteoric rise (see table below). So unless we can flush out the overbought condition, the underlying strength that is evident in the stock market will be in jeopardy.

Source: (Jim Stack) Investech Research