Chris Perruna recently posted an excellent look at recent history’s corrections (which sometimes have been 10%) and then discusses full-blown bear markets and makes note of some key differences.

Specifically, he pulls the camera back to the monthly charts which, I assume, a minority of active traders do. It is important to view the major structure before investing, but also for trading short-term.

I particularly think this statement is important to understand:

“Market corrections and flat markets allow intelligent investors to study conditions carefully while they sit on the sideline patiently awaiting the defining trend. Money is made on the big moves, not the minor day to day moves. Corrections allow big moves to establish themselves.”

Chris then moves on to discuss five tips for the time period in which the market indexes experience a ‘bear’ phase and also provides eight potential signs to look for when a bear market might be on the horizon.

Last week saw some extremely volatile and violent selling pressure hit many high-flying stocks and the broader indexes as well. A sell swing was imminent, but was deeper than most people anticipated.

In the coming week, we have major economic announcements that will help set the tone for the market likely for the rest of the month.

From Yahoo Finance (Investors Brace for More Bad Bank News), here are a few quotes from a recent article:

“Investors are slowly getting a clearer picture of how much in risky and deteriorating debt securities the world’s major financial institutions are holding, and they don’t like what they see.”

“The Nasdaq composite index was hit the hardest last week, as investors’ optimism vanished about the technology sector being isolated from the slowing economy and problems in the financial markets.”

(note, the NASDAQ Index actually declined 6.50% last week)

The next few sentences sum-up the paradox from an inter-market relationship perspective:

“Meanwhile, gold lifted further above $800 an ounce to its highest levels since 1980, and crude-oil briefly breached $98 a barrel, as the dollar plunged.”

(we see key relationships here, with rising inflation and commodity prices being inverse the US Dollar Index)

“The combination of shaky financial markets and inflationary triggers has worried investors that the Fed’s hands are tied. An interest rate cut could send the dollar down even further, but keeping rates where they are might translate to even wider losses for the world’s major financial institutions.”

This is exactly the spot the Federal Reserve does NOT want to be in. Inflationary pressures along with the declining dollar practically compel the Federal Reserve, who seeks to combat inflation, to raise rates to help bring down a bit of the rise in commodities (including near $100 a barrel oil prices), but if the Fed actually raised rates, it would most likely deepen the current credit crisis and potentially curb spending and loans so much as to lurch the US economy into a recession in the months ahead or beyond.

Of course, with the market already shaky and the economy in probable decline due to a variety of factors, the Fed would be most likely to cut rates to help ease the tightening effect of lending policies and help spur the consumer to spend freely again.

It seems like a tenable thing to do until you realize that cutting rates would directly devalue the US Dollar further against other currencies and help spur potential inflationary pressures in the already ’sky-high’ commodities markets (such as gold and oil).

So what is the Federal Reserve to do?

That’s not our business to make their decisions. We, as traders, anticipate and react accordingly.

Either way you look at it, there are a variety of trends to be followed currently and a variety of trading opportunities and asset diversification to be situated now.

For now, it seems the best strategy has been:

Long gold prices and oil futures (or oil stocks)

Short the US Dollar Index (future, etc) or Long other foreign currencies (for FOREX traders)

Short Financials/Homebuilding Sector

Long Technology stocks (this has been a majorly unexpected outlier, or oddity in the whole cycle, which is now crashing)

And eventually, if things continue to play out, Short the US Equities Market.

Perhaps even long Utilities, Consumer Staples, or other defensive style sectors.

We will learn about current inflationary pressures from the Consumer and Producer Price Indexes, and if they have risen too much, expect a subsequent plunge in the market.

Either way, be safe and cautious in the week ahead.

Bonus:  Check out Bondad’s detailed assessment (from the Bondad Blog) on the week ahead from his post “Houston, We Have a Problem.“

Could we be on the verge of a new downtrend on the US Indexes? Let’s look at the past for some clues.

Uptrends are defined as a series of higher highs and higher lows.

Downtrends are defined as a series of lower lows and lower highs.

To change an uptrend, price must first make a new low beneath the recent swing low, swing up and form a lower high, but that is not enough. Price must swing down and TAKE OUT the most recently established lower low and THEN we can confirm that price has begun a new downtrend.

The obvious flaw in this approach is that price will give up a percentage of ground before we can begin official defensive tactics – we will never trade at the absolute high or low in price. That’s a perfectly acceptable approach for greater confirmation of a move underway.

Of course, conflicting trends can occur on different timeframes. A trend change will occur first on the daily chart before it changes officially on the weekly chart.

As we stand right now, the daily charts of the DIA (Dow Jones ETF/Dow Jones Index) are in confirmed downtrends and the weekly chart is pennies away from being confirmed as a downtrend.

Let’s look at the current picture and historical confirmed uptrends and downtrends.

The ‘official definition strategy’ recently experienced dual whipsaws in terms of official classification. We were in a lengthy confirmed daily uptrend and then the August imbalance thrust us into a confirmed downtrend.

Price making higher lows, higher highs, and then taking out those higher highs confirmed us to be in a fresh downtrend (the weekly chart did not confirm a downtrend then).

As of last week, price completed the ‘official definitional switch’ by making a swing low, creating a failure swing (lower high) and then taking out the lower low to confirm the downtrend.

Officially, we are in a confirmed downtrend on the daily chart.

Here is a lengthier, ‘prettier’ chart that details daily price uptrends (green) and downtrends) red:

As you can see in the chart below, if the DIA breaks $130 decisively (Dow Jones level 13,000), then both the weekly AND daily index charts will be in confirmed downtrends.

Stay alert and cautious… and be prepared to change investment postures to more defensive tactics if need be.

The implications from Sector Rotation Theory are showing more bearish/defensive themes are occurring with money flow across the nine major US Sectors.

Over the last 65 days, energy prices led the charge with the greatest sector percentage increase, and we are seeing significant strength as well in the usually dormant utilities sector. Consumer staples (a defensive area) and Healthcare (also defensive) are showing initial signs of strength.

Think of the above chart in terms of left to right progression or flow of funds/money from one sector to the next from left to right.

The bulk of the flow is still centered in the Materials and Energy sectors, with early strength (and opportunities for profit) occurring in the traditionally more defensive sectors (where the “big funds” rotate to preserve capital, rather than earn massive amounts of capital).

As is true with Sector Rotation Theory, there are certain sectors, usually those ‘out of favor’ in terms of the cycle that are experiencing significant ‘outflows’ of cash. At this time, these sectors are the Financials (worst performing sector) and the Consumer Discretionary (retail, entertainment) etc. Taken alone, these developments are quite bearish for the overall market as a whole.

As a refresher, here is the basic progression of “Sector Rotation Theory” as detailed briefly on StockCharts.com:

I have added a red rectangle indicating the possible current location in the market cycle, which corresponds with the “Market Top” location.

Insights from Sector Rotation are somewhat complex, but well worth the effort to study the implications of the theory.

I am relatively surprised with the relative bearish ferociousness that is occurring in many high-flying technology stocks and the broader indexes at the moment. Let’s take a closer look.

We expect prices to move in relatively stable and tradable “swings” in terms of action/counter-reaction, buying impulse/selling counter-impulse in a seemingly perceivable rhythm.

It’s when this “push/pull” rhythm tilts so far to one side that “dislocations” or forced resolutions occur suddenly and often without major warning.

I, along with many others, have been writing about the overextended conditions and the amazing up-swings (actually, powerful sustained upward action) in major technology stocks like RIMM, AAPL, GOOG and others.

This week, it all is coming crashing down with amazing force.

Let’s look and then discuss some ideas (today’s last bar uses intraday readings):

Cisco (CSCO):

There appeared to be a ‘topping pattern’ and potential head and shoulders along with declining momentum through the months of September and October, which should have allowed nimble swing traders and profitable position traders to exit safely.

The problem occurred with the final “last breath” rally in late October and early November. The volume was high and I’m sure emotions were higher. Cicso actually lagged the recent moves in Apple and Google but suffered quite a decline recently.

Google (GOOG):

This is a case of “the greater the move, the harder the fall.” Google has been known to make multi-point moves in a day and Thursday’s action was no exception. Google has experienced a violent sell swing from above $740 to $660 within three days.

Apple (AAPL):

Apple’s recent losses take us back to mid-October, which isn’t so bad, but the problem is the potentially completed exhaustion gap which has formed and trapped all longs who bought following the gap.

Apple still could find support at the rising 50 period moving average, and could – in theory – find support just below the recent gap (as it has been filled), but I probably wouldn’t press my luck if I were holding the bag in this stock right now. Exit if price violates $165.

Baidu.com (BIDU):

This stock really doesn’t look that bad, as the most recent sustained upswing of two weeks was erased in a few days, but then you realize that the most recent sell swing took price down about $100. That is overwhelming.

The Nasdaq Index:

Let’s put all the action into context, and view the NASDAQ Index.

A two-month momentum divergence forecast bearish clouds on the horizon, and the formation of the triangle or wedge consolidation pattern forecast some sort of breakout was imminent. Unfortunately, the break was to the downside.

One had to ask, “How much more buying pressure was left to push high-flying technology stocks higher?” There were also breadth divergences evident in the indexes, as fewer and fewer stocks were making new highs. It just so happened that the ones that were doing so carried more weight on the respective index.

Take time this weekend to run through as many charts as you possibly can and personally annotate them with your observations. This week has the potential to be a great educational lesson if you’re willing to document, print off charts, and catalog your observations of recent price behavior.

Be safe!