S&P 500 – target reached
In our update on October 5, 2018 we discussed a number of bearish developments forming on the daily and weekly charts and warned readers that significant correction is coming. We highlighted that the nature of the pull back is impulsive and expected a decline in the range between 10 to 15% in the month(s) ahead. So far the market corrected 10%, unfolding in a 3 waves fashion and almost reaching our target of 2646.
Investors were too comfortable with a market that was churning higher as it did in 2017 without significant corrections. Technical analysts consider those days as anomalies which have come to a natural conclusion. October, being a seasonally volatile month, has delivered a clear sign that the old quiescent regime is over.
Earlier in the year, and last year, investors supported equity markets by buying the dips. Now, that strategy has given way to more cautious investing as declines since early October have picked up.
S&P 500 – what's causing the sell off?
Rising interest rates in the US, potential policy mistakes by the Federal Reserve, a slowdown in global economic growth, midterm election jitters, seasonal October volatility, worries that the US economy is in the late stages of its expansion, Brexit, Italy’s budget crisis, the looming end of quantitative easing in Europe, cracks in the housing market and ect. have been an overarching theme that investors have been concerned about.
All of these have been a topic throughout the year and Donald Trump tweets every day, so what has been the trigger for the sharp market sell off in early October?
A lot of Algo traders are participants in today’s markets which follow rules based on the market price. This generates liquidity, which is good, but at times can create fast market corrections. While we don’t know all of their secret approaches, lets have a look at a few reliable indicators which are widely followed.
Some may consider Fibonacci numbers as mysterious, others as magical, but the reality is that they are very popular in financial markets and give incredible results. Fibonacci retracements and extensions is one of the most famous application and is used to highlight potential inflection points.
In the monthly chart we take the distance from the 2007 high to the 2009 low and extend it to the upside. At the 161.80% extension the market met strong selling pressure in 2015 which lasted almost a year. The October 2018 top was very close to its 261.80% extension so its not really a surprise the market turned into a selling mode.
S&P 500 – Fibonacci extensions
Let’s go back in time and take the distance from the 2000 high to the 2002 low and extend it to the upside. At the 100.00% extension the market peaked in 2007, at the 161.80% extension the market corrected for a year in 2015, and at the 161.80% extension the market has corrected 10% so far.
What is even more powerful and reliable is the Fibonacci cluster, which is a very potent signal mapping important market tops. The 100.00% and the 161.80% extensions were spot on in 2007 and 2015. The 261.80% extension cluster gave us a range between 2850 and 3000 where a significant top is likely to be in the making.
S&P 500 – divergences
Another very important indicator technicians use is the RSI and the associated divergences, which are fantastic tool to highlight potential market corrections. When the market makes a higher high and the corresponding RSI makes a lower high, we have a bearish divergence which is a clear sign that momentum is deteriorating. In October 2018 bearish divergences have formed on the weekly and daily charts which we discussed in our last update, warning that momentum and sentiment are eroding.
Of particular importance is the weekly divergence, which has implications for the primary up trend. And now that the market is down 10% the question many ask is what will happen next?
S&P 500 – what's next?
Technical analysis does not purport to be able to predict the future, but it uses a range of tools which if used correctly will give a clear picture of what’s happening and in best case will lead you out of the market ahead of the crowd.
So far the primary up trend remains intact and we are not saying that the bear is cage free and the bull is on the menu. However, we want to draw your attention to the points discussed above, which warrants caution with the current technical set up.
In addition, the VIX indicator has broken up, showing that the volatility is here to stay in the near term. The daily 200 day moving average has been broken downwards, throwing negative light on the chart. The weekly RSI broke below its bull market range and the daily RSI entered a bear market territory. Therefore, we are of the view that the current 3 wave decline is part of wave 1 down, of a larger degree 3 wave correction. If our mapping is correct, a corrective bounce (wave 2 up) is likely to take place soon with initial upside target of 2760. Active traders can position tactically and ride the wave up. The shopping list is large as most stocks are currently oversold.
We will watch closely how far the bounce will unfold as it will give us clues about the strength of the market, the likely future long term direction and potential targets. So late in the bull cycle, volatility increases dramatically, so we will be particularly monitoring if the market bounce posts a higher or a lower high. In our view, either scenario will be part of the major top forming process.
What we know so far, is that according to Fibonacci extensions and the RSI indicator, the market is expensive in the 2850 – 3000 range and is vulnerable to a major turn. Despite all the warning signals we see from a basket of technical indicators we don’t want to turn bearish without a confirmation from the price itself. The last arbiter for the truth is the key support of 2532, which needs to be broken to confirm the index is in a bear market state. Until then we treat the current sell off as a correction only.
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