Is this the start of a big downward correction?

The sharp decline off last Friday’s all-time Dow high at 16,650 stretched to about 450 points on Tuesday, hitting a low of 16,200. And that leaves me wondering if this is the start of a big downward correction.

Because I believe that market swings are generated not by the fundamentals (or news), but by the traders’ emotional responses to factors, which include the news, it is essential to try to assess the reaction of traders to this latest decline.

After all, a bull on Friday morning is likely to have experienced at least a glimmer of doubt about remaining a committed bull on Tuesday. In other words, the action of the market determines how we feel towards it.

A constantly rising market, such as we have seen over most of the past five years, had convinced the majority that it is worth investing in equities. At the major low on 6 March 2009, the very same people would undoubtedly have advised selling shares as they appeared doomed.

Remember, markets make opinions.

Markets crash when everyone expects them not to

I read a lot of articles on and Bloomberg. And since Friday, every one of them has expressed the view that this ‘correction’ was badly needed, that it is healthy and in no way the start of a major rout.

Here is a typical quote: “Although we are overdue for a major correction, I don’t think that this is the ‘big one’ – that cataclysmic crash that everyone is waiting for. In fact, it is just that reason, that so many people are expecting a crash, that it will not happen… this time. Very simply, markets don’t crash when everyone expects them to”.

This is an insightful comment, except for one thing. Nowhere have I seen mention of a major crash ahead being forecast by anyone (except for one or two commentators that I follow who rarely appear in the media).

In fact, my impression is that everyone is expecting business to get back to normal following this dip. They’re telling you to buy it, as you have done with great success for the last five years. Just yesterday, I read one prominent guru picking four tech stocks to buy that have crashed by 20% or more! The tech sector has led the charge lower this week.

To paraphrase the above author: Very simply, markets crash when everyone expects them not to!

This confusion is typical, especially at the end of a major market move. Many are saying that sentiment is bullish and others say it is bearish.

The confidence expressed in the above quote relies on the US corporate earnings, which are universally expected to be great and propel the market back up. And that is the conventional view of how stock markets work: Higher earnings = higher stock prices.

But history does not support this iron-clad relationship at all times. It really depends on the context.

The moment of truth

We have had a quantitative easing (QE)-induced stock-market rally for five years and US corporate profit margins are at record levels. To believe stocks can continue with another major rally phase, it appears you must believe profits will continue ever upwards. Also, the reduction in support by virtue of the QE taper will have no effect on stock prices.

My beat is the technical analysis of the markets. So let’s see what the charts are saying. Here is the hourly Dow:

Dow Jones spread betting chart

This is the latest rally and I have an excellent tramline pair working. Last Friday’s high was confirmed by the large negative-momentum divergence (red bar). On Monday, the market made a sharp break of my lower tramline and has spent the rest of the week rallying to the underside of the line in a traditional kiss.

This is always the moment of truth!

Will the market slice through the resistance provided by the tramline, or will it engage in a scalded cat bounce down? There is no way we can say at this stage.

The key to making a low-risk trade

From a purely trading perspective, I have to treat the tramline break as genuine (until proven otherwise). That means I will trade from the short side. And I am able to enter a close protective stop just above the line in the trading channel for a low-risk trade. That is the key.

The point of this style of trading is that you are not making assumptions about the market direction. Experience says that a tramline break is important and a kiss is an opportunity to test the short side.

If the kiss is brushed off and the market rallies, then I suffer a small loss. But if the kiss is genuine, then we are off to the races. If this works out, then I can start to place Elliott wave labels:

Dow Jones spread betting chart

The decline in January is in five waves and the rally is a clear A-B-C, which is counter-trend.

This week’s low is my wave 1 down and the rally is my wave 2. If this is correct, then we are at the start of a wave 3 down.

What could spoil this picture? A solid move back inside the trading channel would do that and I would then be forced to go back to my drawing board.