Correction 2016: What's next?

February 16, 2016 01:00 PM

When equity markets broke sharply last August it was a bit of a shock, especially given the one-day drop of 1000 points in the Dow Jones Industrial Average. But at the end of the day the August move was a standard correction of a little higher than 10%. It had been pointed out that such corrections in the age of the Federal Reserve’s zero-interest-rate-policy have been few and far between, and overdue. 

Basically the market was due a correction, and after it hit, the market rebounded, showing the long-term bull market from the March 2009 low was alive and well and still intact. However, when the market corrects 10%, it is significant, even more so when these events occur twice in a six-month period. One solid correction is expected, two within six months could be a trend. 

So we decided to ask our friends at EidoSearch how strange it was to have such corrections occur so close together. They found nine instances of this (see “Warning signs,” below). 

The numbers are not conclusive. In three of the nine examples the market was down three months after confirmation and in five of the nine examples the market was down a year later, three in which the market was  down double digits. However, all those examples of significant down moves following confirmation occurred during one bear market.  It occurred four times in the 2000 bear market. It might be a little too obvious to say the more defined corrections occur, the more proof of a bear market. Of course, this is true but perhaps not so helpful. By the time of the most recent example in that market move, September 2001, it could best be described as a resumption of a bear market following a mid-trend upward correction. 

Of course, the difference between a correction and the beginning of a market reversal is something that can only be known in hindsight. The best proof that last August’s move was more than a simple correction is the fact that the market could not take out its all-time high set in May. However, the most recent move crossed a trendline from the 2011 correction low and last August’s low, so significant technical damage has been done (see “Taking out support,” below).

 

Interestingly, the most recent bear market following the 2008 credit crisis did not qualify under our original rules. When we adjusted the parameters slightly by measuring a 10% move from a high over the previous [8 weeks] to a 10% move from a high over the previous [six] weeks, there were two occurrences in 2008 (see “A closer look,” below). 

The last four periods had multiple examples: 2008 bear market, 2000 bear market, 1982 and 1974. However, the examples from 1982 and 1974 occurred in the midst of long bear markets. The 1974 example was a resumption of a bear market following an upward correction. The poor performance following this bears that out. The 1982 moves represented capitulation of the same bear market that lasted from 1965 to 1982 (see “When they happen matters,” below). This does not bode well for the current market because we have been in the midst of a secular bull market, which has lasted since the March 2009 low. 

However, the 1957 example in “A closer look” is more relevant and provides some hope. The market rebounded solidly despite being eight years into a bull market. That bull market lasted from 1949 until 1965. The question for traders is if the current example will follow the 1957 path or the more recent example from the 2000 and 2008 bear markets?  

If we continued to adjust the parameters for market moves in the midst of long-term trends, we are sure to come up with additional examples. We must remember that setting specific criteria is arbitrary and conclusions drawn from them can be dangerous. Systematic trading legend William Eckhardt requires 1,800 examples of a trade set-up before deciding whether to use it in his strategies. We only provide you with a dozen. 

What is clear from these examples is that if a larger move is in the wings, there will likely be opportunities to exploit it. The market will rebound and if it once again fails to make a new high, there will be another and more severe move lower. 

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.