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Stocks Preparing for a Correction: Buy Bad News, Sell the Good


The best thing to do is wait for a technical breakdown and reversal.

The S&P 500 (INDEXSP:.INX) remains in a strong uptrend, but the index has posted a sizable gain for 2013 so far, so it's only logical that a pullback within this bull market will take place sooner rather than later.

With May now upon us, prices historically fall more times than not , and I feel that a three to four week correction is on the verge of starting. Last Friday, we had very strong economic numbers confirming that the economy is recovering. This news sent stocks sharply higher as shorts cover their positions and investors who were not yet long got into position to profit from higher prices. But the herd psychology and its trades are typically incorrect as the herd invests based on fear and greed. The old saying "buy on negative news and sell on positive news" will typically get you on the correct side of the market more times than not if used with price, volume, and cycles.

The Technical Traders' View: S&P 500 Index Weekly Chart

If we look at the price of the S&P 500, we need it to break down below the recent pivot low before I become bearish.

Volume, which is not shown on this chart, is below average as price moves higher; this is also a bearish sign.

Looking at a basic cycle using the stochastics indicator, we can see that the current cycle is starting to turn down. Cycles tend to lead price during an uptrend so we could still have stocks move higher for another week or so... but be aware that when price starts to drop, it's likely a market top. But until then, you must respect the uptrend. Stocks can remain overbought and toppy-looking for months, so don't be gambling and trying to pick a top until we see a breakdown start.

The Technical Traders' View: S&P 500 Stocks Trading Above 200-Day Moving Average

Stocks trading above the 200-day moving average is a great indicator for helping spot broad market underlying strength/weakness. It does lag the market, but it is still very powerful. The chart below shows this info and my thinking of what is likely to unfold sooner than later though price may still rise for several days yet.

I also use a similar chart for timing swing trades and market tops, which are based on stocks trading above the 20-day moving average. This chart is not shown here, but it is now trading at a level that generally triggers a selling/market top.

Stock Market and S&P 500 Trading and Investing Conclusion

In short, I am still bullish on the market as I focus on trading with the trend. I do not pick market tops and I do not pick market bottoms. Knowing that stocks make their biggest moves at the end of a uptrend and at the end of a downtrend, it's only common sense that risk is extremely high if you are betting against the current trend.

The best thing to do is wait for a technical breakdown and reversal, which puts the odds more in your favor with much less risk; plus, there is typically a clear line in the sand to exit the position if you are incorrect.

The last major stock market top, which formed in September of last year, had a series of strong news and strong price action persuading the herd to buy stocks. Instead it was the last impulse wave up just before a strong correction took place. That is much like what we see now with the economic news.

Editor's Note: Chris Vermeulen offers more content at his sites, and Traders Video Playbook.
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No positions in stocks mentioned.

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