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PAWS 2 - The Correction Continues



We highlighted how spoiled our new family puppy was, and through the analogy, inferred a market consolidation was necessary because traders and investors may have also been spoiled by sharp upside off the September 30 low. We now return to our puppy analogy to see how the consolidation/correction process is working. In properly training Logan to stay on our property thus avoiding traffic, we installed an electric fence and have to draw the puppy toward "the line" in order to give him a necessary "correction" (read: Shock). This seemingly mean, yet ultimately harmless action is taken to teach him what can happen if he doesn't focus on his boundaries. Is a rapid market move toward near-term overbought extremes any different?

Sometimes the hardest aspect of trading or investing is the art of exercising patience. There has been very little change in the fundamental backdrop over the past few weeks and even months, which means that many eyes are fixated on the technical backdrop of the market to determine near-term direction. From our vantage point, the equity markets are in the midst of a consolidation/correction period that may last a bit longer. On October 13th, we noted the widely followed major market indices had reached a level of overbought that needed to be relieved. The relief can occur through price, time or a combination of the two.

In our view, a combination of the two is the most constructive and is most likely to draw in buying interest once completed. A sharp decline just brings in the "buy for a bounce" crowd, while just time of moving sideways draws in the "I'm bored, so why not" folks. Both influences are very brief in nature. When combining both price decline and time spent, it creates some level of fear that the consolidation/correction is something more meaningful than at first believed, thus allowing for a more diversified buyer to become interested as prices decline.

The recent consolidation period has thus far been constructive in alleviating the overbought condition and is moving toward levels of oversold that have generated rallies to new highs since the low in March (overbought/oversold indicator is 14-period daily stochastic). Rather than tell you...let me show you. "Hey kids...stop shocking the puppy...he has already learned his lesson!"

S&P 500

Dow Jones Industrial Average

NASDAQ Composite Index

Russell 2000

Charts provided by Reuters.

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No positions in stocks mentioned.
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