February Review: Stocks Still In A Correction

February Month In Review:

This month marks the one year anniversary from the March 2009 bottom in the stock market. Each of the major averages have enjoyed tremendous gains over the past 12 months as the global economy continues to recover from the worst simultaneous bear market and economic recession since WWII! After that tremendous run, the major averages have spent most of 2010 consolidating their recent move. The latest correction began on January 22, 2010 after all the major averages sliced below their respective 50 DMA lines on heavy volume and we are now waiting for a new follow-through day to emerge.

Bullish Case:

It is very easy to adopt a gloom and doom mentality towards the recent action in the market. However, it is very important to step back and put the recent correction into proper context before passing judgment. As of this writing, the deepest the market has pulled back since the March 2009 bottom was -9% from its post recovery high. This is a bullish sign for this new bull market since every time the market has pulled back the bulls have promptly showed up and quelled the bearish action and defended support. Second, history shows us that most bull markets last anywhere between 18-36 months before they fail. Therefore, the fact that we are only beginning our 12th month bodes well for this somewhat young bull market. Third, and perhaps most important, nearly every government across the globe stepped up and unanimously infused an unprecedented amount of capital into the global economy. This unified action saved the global economy from entering a deeper recession and laid the foundation for this robust rally.

Bearish Case:

The US dollar continues to play an integral role in global capital markets. Since November, the greenback has rallied smartly and jumped above its 50 and 200 DMA lines. As expected, the stronger dollar sent US stocks and a slew of commodities (i.e. dollar denominated assets) lower as investors continue to debate our economic future. The bears believe that the effects of the massive worldwide stimulus packages from 2008-2009 are beginning to wane and the future of the global economic recovery may not be as robust as initially expected. The bears also claim that technically this rally is done and overdue for a serious intermediate term correction. Since the March ’09 lows, the major averages have retraced (rallied back for) approximately +50% of their 2007-2009 bear market decline, which is a fairly typical bounce before a new down leg ensues. Only time will tell exactly how this plays out. Until then we must remains cognizant that the market is currently in a correction and shall remain in a correction until a new proper follow-through day emerges.

Market Action:  Price & Volume D+
The major averages topped out in October 2007 then proceeded to precipitously plunge until they put in a near term bottom in early March 2009. Since then, the market snapped back and enjoyed hefty gains which helped send the major averages to one of their strongest 10-month rallies in history. The small cap Russell 2000 Index was the standout winner, surging a whopping +90% before reaching its interim high of 649.15 on January 19, 2010. The tech-heavy Nasdaq Composite is a close second, having vaulted +84%, before reaching its interim high of 2,326.28 on January 11, 2010. The benchmark S&P 500 Index raced +73% higher before placing its near term top of 1,150.45 on January 19, 2010, and the Dow Jones Industrial Average soared +66% before printing its near-term high of 10,729 on January 19, 2010.

This data indicates that Tuesday, January 19, 2010 appeared to be a very important day for the market because that is the day that most of the popular averages placed their near term tops. Over the next few days, the market got whacked with heavy distribution and more negative reversal days (open higher and closed lower) which put pressure on this 46-week rally. Then on Friday, January 22, 2010 all the major averages sliced and closed below support (their respective 50 DMA lines) on heavy volume. The fate of the rally was sealed at that point because all the major averages entered a correction due to the series of distribution days negative technical action in the major averages and several leading stocks.

Conclusion:

Until a new rally is confirmed, it is best to avoid new buys, since history shows us 3 out of 4 growth stocks follow the major averages. Looking forward, a new rally will be confirmed only when the market manages to produce a sound follow-through day. Until then, patience is king. No one knows for sure how low this correction will take the market, so instead of guessing we shall simply continue to react intelligently to what we see happening. This simple, yet effective, strategy has served us well through both bull and bear markets. As always, we will continue to objectively analyze price and volume to better understand the market’s underlying health.  Never argue with the tape, and always keep your losses small.

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