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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. The Market Timer Map is based on key technical, fundamental and sentiment drivers.

Earlier this week, I looked at the bullish drivers that would propel the S&P to new highs above 1900 before summer. Today, I'm focused on 5 bearish trends that could temporarily de-rail the bull train this month if he doesn't get up and get going soon.

In the spirit of "keeping your enemies closer," we want to know the bear case well and be ready to join them in the short-term if it looks like a bigger correction is going to unfold.

5 Bearish Warning Signs

1) Russell 2000 Small Cap index breaks down below 200-day moving average

2) 10-year Treasury yields fall to 2.6% as fears about war and deflation mount

3) Heavy "distribution" of growth stocks from Technology to Biotech

4) Heavy sector rotation away from growth areas to defensive, safety areas

5) A mature bull market, with big gains on the table, entering "worst six months"

When you add up these bearish drivers, it's hard not to turn a little bit cautious in the short-term, or at least have one eye on the exits.

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

How Soon?

There are clearly big disconnects going on in the market as many institutional investors flee growth stocks and run to bonds and safer sectors. The defensive flight to safety, away from Consumer Discretionary, Financials and Tech to Utilities, Staples and Energy is enough to make a bull like me a little nervous.

And we have to wonder if the money that is rotating into big caps is just masking the broader market break-downs. In other words, is the S&P 500 destined to follow the Nasdaq and the Russell 2000 back toward its own 200-day moving average, or lower, once all the rotation and reallocation is over?

More . . .


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Right now, the S&P is still trading above levels that argue for new highs. Specifically, there are several levels of support where institutions have shown great buying interest between 1780 and 1860.

Since the April 4 highs at 1897, buyers have come in at 1815, 1850 and 1860. As I write on Friday afternoon, the index has bounced off of its 50-day moving average at 1865 yet again.

But this ship could easily turn quickly south and start plowing through those supports. For me right now, I will shift more defensive on a close below 1850. And I will start thinking correction if we lose 1820.

Because even though 1780-1800 will offer some support, if the S&P gives back the ground it has gained in the past four weeks since 1815, then the tide is probably turning against the bulls for the summer.

So to answer "how soon?" it's all about the strength of the price trend. A strong S&P will lift the Nasdaq and Russell 2000 with it. A weakening S&P could get the ball really rolling for a double-digit correction.

How Bad?

A trip down to the 200-day at 1782 would only be 6% off the highs. And even a test of the Feb lows at 1740 would only be 8.3%. The S&P could definitely find good support in those areas and stave off a double-digit correction.

In fact, there will probably be good bounces off those levels the first time they hit. But if the market climate takes a worse turn, whether due to poor economic data or geopolitical crisis, then the next "magnet attractors" of price will be 1700 and 1650.

If waves of selling take over in the next few months - 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. And 1650 could give way to test 1600, and then last June's lows at 1560 will be the target 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. 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.

If such a volatile ride unfolds, I can picture a scenario where the S&P does get all the way back down to those June lows near 1560. Because that would be a good test of the longer-term breakout that happened when the index surpassed the 2000 and 2007 highs. And I will be a big buyer down there looking for S&P 2000 by 2015.

How to Prepare?

The best way to prepare for a correction is to have a plan. When I draw up my monthly 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.

Often, grabbing those key entry points that give you a well-defined risk/reward "edge" can put you in the right positions for a larger 5-10% move if key support or resistance is broken.

What I do is identify key support and resistance levels in advance 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 us 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.

And Then, When I Pull the Trigger . . .

You can be there with me, receiving email alerts from our private service where I follow the map mentioned above: Zacks Market Timer.

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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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