Mini Correction or Full-Fledged Stock Market Crash Ahead?

Could it be that the largest IPO in history signalled the top of the stock market?

That IPO was e-commerce behemoth, Alibaba, of course, recently listed on the NYSE.

By the time the Alibaba rang the bell in September, the Aussie market was already well on its way down. The ASX had lost 4% from its six year high by September 19 — the day of Alibaba’s record-setting initial public offering. It’s now fallen close to 9% from its peak.

While the US market drop came a few weeks after ours, it too is now being overrun by the bears. The US market bellwether, the S&P 500, has lost 6.8% from its peak and is approaching a full correction. A correction, by the way, technically means a fall of 10% or more.

The fall in the US stock market following Alibaba’s listing wasn’t entirely unexpected. It’s been over three years since the last correction. And volatility is now more than double the level it was in July.

Signs of what’s to come

On Monday night, three weeks on from its peak, the S&P 500 Index, fell through a significant support level. It lost 1.7% for the day, falling sharply below its 200-day moving average.

The 200-day moving average is one of traders’ most looked to indicators. It tends to act as a strong support or resistance level. And it’s a good measure of long term investor sentiment. When the price is above the moving average, bulls are said to be in control. And when it trades below, bears run the show.

Looking back over the past century, a strategy based simply on trading the 200-day moving average performed significantly better than a buy and hold strategy.

For this reason, traders are paying close attention to the moving average this week. If the index had held above the 1,905 level — Monday’s 200-day moving average — it would have been a strong bullish sign. Many were hoping the index would bounce once it reached the support level.

But as you can see in the chart below, it didn’t. There were a few attempts to explain Monday’s drop through this important threshold at 1,905 and its further fall through the past support level of 1,900.

The first case of Ebola contagion in the US was thought to play a part. It did hit airline stocks, but that was really the extent of it. Oil prices falling to record lows was also blamed. While cheaper oil hurts energy stocks, the wider economy benefits, so this is unlikely to be the cause of the overall market’s drop.

The most likely reason was simply automated computer trading that accelerated selling as the technical level was reached.

Some relief came last night as US stocks attempted to recover. In a sign that the market may hold around this support level, the S&P 500 finished the day more or less flat. But it fell late in the day, dragged down by energy stocks as oil prices hit new multi-year lows.

The fall through its 200-day moving average on Monday doesn’t necessarily mean the index will fall further. If the price can hold above this level — even after having briefly fallen through — it is a strong bullish signal.

Hitting a support level will often get investors excited, stirring enthusiasm for stocks. If the support level holds it may prove to be an excellent buying opportunity, seen as a mini correction, from which a move higher can be expected.

Three mini corrections have already been overcome this year. The US index had two mini corrections each of 4% in April and in August. And prior to this, in February, the index lost 6%, before resuming its run higher. At this time, it also fell below its 200-day moving average, but managed to recover and resume its longer term run.

In fact, when the S&P 500 has fallen below its 200-day moving average over the past ten years, more often than not, the index has moved higher. 69% of the time that the index fell through its moving average, it was higher one month later. And 86% of the time, it was higher three months after breaching the psychological level.

Going off past examples, the S&P 500 falling below its 200-day moving average on Monday night could actually be a bullish sign in the short term.

This is in contrast to the longer term — 100 year — track record of trading the 200-day moving average, as mentioned earlier.

And it contradicts a common belief of traders. It’s said that if a stock, or index, or currency, etc. is in an uptrend and then falls below its 200-day moving average, 60% of the time it will continue to fall. And if a stock in a downtrend rises above its 200-day moving average, it will continue higher 60% of the time.

However, going off recent history, and last night’s pause, it seems there’s a good chance that the US market will rebound in the coming three months.

The fact is that we can’t perfectly predict where the US market, or any, is headed. While technical indicators can give us some clues, I urge you not to put too much faith in any one.

And don’t forget other factors are at play. In the short term, the direction is likely to come down to how investors respond to companies’ quarterly results in coming weeks.

What you should expect is EITHER a bounce higher or a sharp drop lower. I expect the US market will move strongly away from its current level, whatever the direction may be.


Meagan Evans
For Markets and Money

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Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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