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Correction Watch: How Soon? How Bad? How to Prepare?

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Every month, I make a fresh "map" of the market that helps me define the highest probability scenarios for the S&P 500 over the coming weeks. My map is based on technical, fundamental and sentiment data points.

Those data points come from lists I make of longer-term bullish and bearish "market drivers" that help me keep on top of the major trends influencing stocks. Earlier this week, I looked at bullish factors that would propel the S&P to 1800 in the next six months.

Today, I want to focus on the bearish list because it just got longer than it has been all year. And it says we could be in for a nasty correction before stocks make new highs. Here's my current top-ten list...

1) Slowing economic growth and mixed leading indicators
2) Stalling earnings growth and disappointments from key bellwethers
3) Fed tapering before economy can stand on its own
4) Current length of bull market at nearly 54 months is at upper end of historical norm
5) Rapidly rising interest rates choking off housing recovery
6) Multiple technical indicators flashing warning signs as charts break down
7) Washington debt ceiling and budget battles brewing
8) Departure of Steady Ben from the Fed and anxiety about Summers as replacement
9) Nearly 20% gains on the table for lots of correctly bullish investors in 2013
10) Margin debt near record levels seen at the market peaks in 2000 and 2007

MORE . . .


Buy When Others Are Selling

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When you add up all these bearish factors - especially as we head into what is historically the weakest time of the year for the stock market - it's hard not to turn cautious in the short-term.

While I remain bullish in the long-term, I am preparing myself and my Market Timer group for ways we will capitalize on the impending correction. Here are the three questions I'm focused on right now...

How Soon?

From the looks of this list, if a correction is coming this fall, it is going to start very soon. The biggest event on the horizon is the September 17-18 FOMC meeting. That Wednesday will either be the start of the Fed's "tapering" of bond purchases, or clearer guidance about when the taper begins and how much it will shave from stimulus.

Whatever the exact details, we know that "the beginning of the end of QE" is coming. The Fed has to taper because the deficit has shrunk and the Treasury needs to issue less new securities. The bond market is already pricing-in this fact. So, who cares, right? Apparently a lot of investors do as homebuilder stocks and other interest-rate sensitive industries are getting hit.

As irrelevant as the taper seems, if it comes in the context of the Fed also lowering economic growth and inflation forecasts at that quarterly meeting (this is very possible), then stocks are in trouble. My best estimate is that there is a 60% probability stocks will begin to sell-off dramatically before that Fed meeting. And that's because there is another event on the horizon: the debt ceiling.

Recall that this political battle was postponed earlier this year until September. Wall Street has been completely free of Washington brinkmanship for 8 months. Odds are the circus is coming back to town.

How Bad?

When I look at my charts every day, I see the same important levels of support that this market could challenge. The first one we nearly touched and bounced off of this week is S&P 1635, Market Timer was a buyer there. The next levels are a band around 1600 (1590 to 1610) and then a bigger zone of 1550 to 1575 below that.

1556 is the site of the 200-day moving average right now and 1560 was a price level we bounced off of in June that represented about a 7% correction. My Market Timer group was a buyer of that correction on June 24 as we anticipated several days prior that 1570 would be strong support.

If waves of selling take over in the next few weeks - and they can easily do so if there is what I call a "buyer's strike" where cash-rich investors stand aside to "wait and see" - then we will visit each successive level of these supports. A break in each gives way to the next. In its simplest form, 1635 could give way to test 1600 and then the June lows will be tested after that.

As Mr. Market is fond of doing in these sell-offs, he won't make it easy for bulls, or even bears, to find their footing. I am very good at timing bounces, but I don't catch every one. And the relief rallies that catch bears off guard - or fool bulls who think they've missed the turn - will just be another joy ride on the way down.

So just when investors all move to the same side of the boat, bullish or bearish, Mr. Market will pull the rug and tip us back the other way. You have to be able to anticipate these moves. Because this volatile ride down, with the VIX spiking above 20, could just be a dress rehearsal for the full double-digit correction that would take us all the way down to S&P 1500. And I'll probably be a big buyer down there.

How to Prepare?

The best way to prepare for a correction is to have a plan. As mentioned, every few weeks I draw up a fresh map of the market that defines my highest-probability scenarios for major price action. My goal is to be on the right side of the 2-5% swings that can happen every week, and that often put you in the right positions for a larger 5-10% move.

What I do is identify key support and resistance levels and determine windows of probability for the S&P to trade within, given those price ranges. I also assign odds to a more meaningful breakout above, or breakdown below, the outer levels.

What my "Scenarios & Probabilities" map gives me is a systematic decision-making tool. I am either a buyer at key support levels of bullish leveraged index and sector ETFs, or I know when the level is violated and the next support is in play. And that's when I decide if we will flip to bearish leveraged ETFs.

By far the most important dynamic of market timing, besides knowing how to identify and use support and resistance, is how you allocate capital. My map not only defines my risk, it also tells me how much to bet to make the most of every opportunity. I wouldn't enter a trade without it. Especially a trade that is headed into correction season.

Where to Get the Map and Find the Trades

If you know where to look and are prepared to act quickly, you can profit no matter which way the market turns. Even if it heads south. I am directing a private Zacks portfolio that provides timely buys/sells to take advantage of quick, explosive swings in industries, sectors and the market as a whole.

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Good Investing,

Kevin Cook

Kevin, a Senior Stock Strategist at Zacks, is a recognized authority in global markets and renowned for predicting market swings. A former market-maker in the $4-trillion-dollar-a-day world of interbank trade, he developed the ability to track the movement of money, and trained his reflexes to take advantage of it. Today he directs the Zacks Market Timer, providing commentary and recommendations.

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