How Low May Stocks Go With an Inevitable Correction?

Deron Wagner |

“The market can remain irrational longer than you can remain solvent.” This famous quote by economist and speculator John Maynard Keynes may be appropriate in the current market environment, where the main stock market indexes have been seemingly unstoppable for months. Investors who have been waiting for a substantial pullback to enter the market can relate. Active traders who have been selling short in anticipation of a reversal can most certainly relate. But in such a bullish environment, it is crucial to remember that markets still indeed move in both directions, and every strong trend eventually has a substantial countertrend retracement. As such, let's take a basic technical look at the chart of the benchmark S&P 500 Index (^GSPC), in order to predict where stocks may find support when the inevitable correction comes:

SPX - Daily CBOE S&P 500 Index(Click to enlarge)

With regard to technical analysis, I am a big believer in keeping it simple. While occasionally using other indicators, I predominantly use moving averages, trendlines, and support/resistance levels (in addition to price and volume). On the chart above, the teal colored line is the 20-day exponential moving average, the pink line is the 50-day moving average, and the orange line is the 200-day moving average.

The first and most important thing to observe on this chart is that the S&P 500 has been in an extremely steady uptrend since the beginning of the year. An uptrend is simply defined as a series of “higher highs” and “higher lows,” which are clearly in place.

Although it's impossible to predict when it will happen, when the correction eventually comes, the first level where the index may find support is in the area of its 20-day exponential moving average and intermediate-term uptrend line (“A”). When the S&P 500 comes into support of this level, either through trading sideways or a price retracement from its high, it will be important to observe the price reaction. There is a very good possibility that such a pullback will merely result in the index subsequently moving back up and resuming its dominant uptrend. This is simply because the longer a trend has been in place, the more likely the trend is to continue. Furthermore, one must always assume a currently established trend will remain intact until the price proves otherwise. Anticipating a trend reversal that has not yet happened is a dangerous game that cannot be won over the long-term.

If the S&P 500 convincingly moves below the near-term support level (“A”), the current intermediate-term trendline will be broken, but the uptrend will NOT yet have reversed. Most likely, all that would happen is the index retraces to more substantial intermediate-term support of its 50-day moving average (“B”). As the 50-day moving average is frequently used by banks, mutual funds, hedge funds, and other institutional players as a retracement level to start buying stocks, I would expect such a pullback to the 50-day moving average to subsequently result in a substantial bounce. As such, the first touch of the 50-day moving average within an established trend is usually an ideal, low-risk buying opportunity.

Finally, the index should find major support at the “swing low” from earlier this month (“C”). As long as that level holds, a “lower low” would not be established, which means the uptrend would still be valid.

So, what would signal an actual trend reversal? Several things would have to happen. First, the S&P 500 we need to convincingly (not just a one-day probe below) breakdown below point “C” on the chart. Then, the 50-day moving average would need to start turning lower, followed by the 20-day exponential moving average crossing below the 50-day moving average. Only then would I remove all bets on the long side of the market and start initiating substantial short positions. Nevertheless, with such a solid uptrend in place, it would likely take a minimum of a month or more for all those things to happen, even if stock started pulling back today.

In conclusion, the broad market remains in a healthy technical uptrend, and we do not yet have any reason to believe the trend is going to reverse anytime soon. Therefore, I will continue to enjoy trading in the dominant direction of the trend for as long as it lasts. Still, it pays to be prepared by knowing key support levels when the retracement comes, so that stops can be adjusted on open positions, and plans can be made for new buying opportunities.

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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