Technical Talk: A correction – not a top

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The comments below were provided by Kevin Lane of Fusion IQ.

A few days before the correction began, we stated:

“Now that said, can we have a correction of five to ten per cent? Of course!! However, we continue to find it hard to believe the ‘top’ is in play when everyone continues to call for it! After all, tops are formed when everyone becomes so comfortable with stocks they invest all their available liquidity without hesitation or a care in the world. And clearly that is not the current sentiment.”

We further stated, “Again it is very likely we will have some semblance of a decent size pullback soon, seeing the S&P 500 has run up 10% from just November 2009, 31% since July 2009 and 64% from the March 2009 lows.”

However, do we think a major top is in? The answer again remains no.

But regarding the protection of capital from a drawdown or the risk of putting new money to work today, a different answer is required. The answer in this scenario is the run-up in equities puts investors at risk to a correction, not a top, but a correction. Our guess is that the correction would be similar in size and scope to the June/July 2009 correction that saw the S&P fall 9.0%.

All that said, we still believe this is a correction. Corrections tend to be fast and furious and down 5+% on the S&P 500 in five days would meet the definition of fast and furious. We do believe this corrective wave will go lower still, likely another 5% before we see a more sustainable bounce.

At this stage we are of the opinion that stop losses should be honoured and risk disciplines adhered to as corrections (even though they may not be tops) can be very painful if one just watches like a dear in the headlights. A 10% correction would take the S&P 500 down to its first Fibonacci retracement (support) level near 1,035. Near that level we would expect the market to stabilise.

Our faith that this is not a major top lies in several observations: First, many industry groups still remain in positive price trends (even with the current sell-off taken into account). Second, sentiment remains too negative and disaffectionate towards stocks for this to be a top. Tops are formed on excessive optimism, complacency and a lust for stocks (none which presently exists). Last but not least, investor liquidity remains more than adequate as most asset allocation surveys still have equities underweight relative to their historical norms.

So for now the tape remains defensive and the sellers for the first time in a while are in control of that tape. While this condition exists it will be hard to see anything but shallow bounces.

However, at lower levels we believe buyers will re-emerge. When they do, along with the negative sentiment and trading strategies that are currently in place, equities are likely to surge once more.

Source: Kevin Lane, Fusion IQ, January 27, 2010.

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