After suffering the biggest loss in two years the prior week, the S&P500 registered another, this time even larger, loss last week. Dropping 5.2% by Friday’s close, the S&P500 officially entered a “correction” which means it’s lost more than 10% from the peak. The last time this happened was in early 2016, almost exactly two years ago. While volatility rose again last week, by Friday’s close, the VIX index had backed away from its intra-week highs. And trading volume surged, as some investors actually rushed to sell and get out of the stock markets.
All that said, let’s remember that a 10% loss, so far, is really not a huge deal, especially given the parabolic move upward that the S&P has enjoyed over the prior 3-4 months.
From a technical analysis perspective, the S&P’s drop magically stopped just at the 200 day moving average, which most technicians would agree is always a strong support level. The question now is whether the S&P will bounce all the way back up to its highs, or will it re-test and break below its lows…..near the 200 day moving average.
This test will happen soon. Since most of the market has been conditioned to “buy the dips”, for this buying pattern and buying psychology to continue, it must work to regain the old highs over the next several days. If not, then the 10% peak-to-trough loss will almost certainly cause a huge percentage of investors and traders to change their trading strategy—from buying the dips to selling the rallies. And if this happens then there will be very little to support the S&P500 until a far larger loss is incurred.
As described a few weeks ago, this is why parabolic moves upward do not correct with a sideways pattern; instead they correct with sharp drops. After large parabolic moves higher, value buyers—or potential stock buyers who would be willing to step in and catch falling knives—will naturally require far larger percentage drops in stock prices to justify the risk from buying falling knives. If value buyers enter too soon, they will risk buying at prices that are too high and will therefore suffer losses until the stocks they just bought find a more stable bottom. So they will not buy unless prices fall a lot more than 10-15%.
So this upcoming week will be critical to determining which way the S&P moves—back up or back down. One thing is almost certainly not going to happen—the S&P500 will probably not remain in a super narrow trading band.
And with the suppressed volatility regime now over (VIX has exploded upward over the last two weeks), we should expect to see another bumpy ride for the S&P, regardless of which direction it ultimately moves to—back up or back down.