Correction/consolidation likely in progress

Ireland woes, Cisco disappointment, China tightening fears...pick your excuse. When the market is ready to go down it doesn't matter what the excuse is because it's gonna go down. There's already talk about Ireland getting a bailout so maybe this causes a dead cat bounce back to 1220. But bounce or no bounce we're likely in a correction or consolidation phase for the next 2-4 weeks.


I like to check the advance/decline line anytime the market breaks above a prior high. If it makes a new high along with the market it confirms the bull market is intact because the internals of the market are strong. Near bull market peaks you tend to see a divergence between the market and the A/D line. Near the top as the market makes new highs, the A/D line doesn't, signaling weakening internals. A flagrant example of this was the bull market peak of 2000 whereby the A/D line had peaked in 1999 and was in steep decline until the market peaked about a year later. In 2007 when the market hit a new marginal high in October the A/D line didn't confirm, as it did not pass above the high it made earlier in the year. I circled this below on the chart. That was a warning sign not to trust that new high. Just prior to this dip the A/D line had made a new high alongside with the market making a new high thus giving the thumbs up for the bull market advance. This strongly suggests any downside from here would only be a correction not the beginning of a new bear market.

In addition, as far as I can tell no bull market has ever died before its 2nd birthday and if you're still calling the move from March 2009 a bear market rally you are in serious denial. But hey, I'm not going to get complacent about anything...ever. There's no law that says a market can't make a LT top with a strong A/D line...history however is strongly against this happening especially when there is still so many LT skeptics with consumer confidence closer to historic lows as opposed to historic highs which is when LT tops are made. You gotta go with the odds and the odds say correction no matter how scary it may get. The same above analysis could have been made in April just before the flash crash and that was indeed one scary decline. However, this time around the potential for downside is not as high because a) bond yields are far lower now than they were in April and b) Traders were more complacent in April compared to now as evident by the put-call ratio, Rydex ratio and VIX.

Observing how traders react to the downside will be the key to knowing how long and deep this will go. Already, the froth is unwinding with the put-call ratio reaching  0.97 on Friday and the VIX popping 10% . It’s just a 1 day reading though. We still have a ways to go before unwinding the froth