Let's Get Ready to Rally...
Sort Of
By Jeff Clark
March 06, 2007
It's time for a bounce.
Let's be clear... the correction still has a way to go. But stocks are ready for a short-term rally, which ought to get started any day now.
We're witnessing an A-B-C correction. Here's how it goes...
The correction starts with a swift move lower, which catches everyone leaning in the wrong (bullish) direction. Investors, who were too aggressively long, liquidate positions. And traders, fearful of missing out on a big downside move, load up on put options and short stocks into weakness. This is what happened last week.
Then, just as everyone is loaded up for the big decline... the "B" wave hits.
Stocks bounce back sharply and rally up toward a natural resistance area, such as the 50-day moving average line. Traders who bet too heavily on the short side get whipsawed as they unwind their short positions and try to get long.
Once the market has shaken out all of the ill-fated short bets, the "C" wave takes hold.
The final leg of the correction takes stock prices below the "A" wave lows, instills a good deal of panic among investors, and creates the bargain environment that'll fuel the next leg of a bull market.
Yesterday's action quite likely completed the "A" wave. Stocks have sold off sharply for several days, many of the technical indicators we follow are now at extremely oversold levels, investors are downright pessimistic, and the taking heads on CNBC are starting to show concern.
Like I said... It's time for a bounce.
Most traders, however, will be better off using a "B" wave rally to lighten up a little on long positions and to establish short positions – because there's a lot more downside ahead of us.
Take a look at the following chart of the Nasdaq Composite Bullish Percent Index (BPCOMPQ):
This indicator is a simple measure of whether the stock market is overbought or oversold. Over the past few years, market corrections started when the BPCOMPQ rallied above 60 or so and then turned down. And the corrections typically lasted until the BPCOMPQ dropped into the 30s.
The current reading of 55 tells us there's still plenty of room left for the market to keep selling off.
So enjoy the brief rally. But get ready for more downside once the bounce has run its course.
Best regards and good trading,
Jeff Clark
