The First Significant Correction of the Bull Market Appears Confirmed

The cautionary flag we raised in last Thursday’s entry has turned from yellow to red. In spite of some outstanding performances by individual stocks, such as Amazon.com (AMZN), the market has suffered continued and incessant distribution. Intermediate term investors belong in cash. The market is now for traders only.

Distribution is a warning but we’ve seen distribution before throughout the rally and where it’s been heavy all it’s led to have been brief pullbacks of 4 - 8% followed by more aggressive upside. Why do we feel this time is different? It’s in the stocks. We’re seeing break downs instead of pullbacks. That’s a huge difference.

Many leading stocks now trade below the 10 MA’s on their weekly charts, an important last line of support for aggressively uptrending stocks. And a good many of them are Chinese ADRs, which have been a key leadership component throughout the bull market. Yesterday the Shanghai Composite staged a breakaway gap to the downside on increasing volume for the fourth distribution day of its current rally. This is a poor turn of events for the dominant bourse of the international bull market, which had recently broken through important resistance on volume and appeared poised for new yearly highs. What is notable is that during the initial stages of that market’s correction in August Chinese ADR’s held up well on the American markets. Not so Tuesday as many have now entered pronounced downtrends.

Most prominent among these is BIDU, perhaps the one true institutional leader from the menagerie of Chinese ADRs, thus making it the most meaningful for market interpretation. The stock had improbably soared off the March market bottom against incredible odds. Price was buried under an avalanche of overhead supply by falling more than 75% off its all time high. Stocks that fall that hard rarely stage a second act, and if they do it can take years for them to recover. But BIDU managed to quadruple en route to new all time highs.

BIDU reported impressive earnings and sales after Monday’s session. But they guided lower for the 4^th quarter due to a new advertising delivery system that they fear could cause some disruption in their business. The market’s response on Tuesday was swift and brutal.

You might expect this in a stock that has quadrupled and is pregnant with longs that have both hefty gains to lock in or were late to the party and scurrying to cut their losses. But that’s not the type of behavior we saw earlier in the rally in reaction to bad news in market leading stocks.

Take Vistaprint (VPRT). At their last earnings call they guided below consensus. The stock gapped down but lost less than 5% and went on to make new 52 week highs eight sessions later and continued to appear on the list in the ensuing months. In fact, it was one of the dwindling number of 52 week highs during Tuesday’s session.

And what of Arcsight (ARST)? In June ARST beat The Street but guided lower for the following quarter. Tremendous share price volatility ensued but the stock actually closed higher the session after the report was released. It, too, went on to make further appearances on the 52 week high list.

The reaction today to BIDU marks a shift in sentiment. Bullish markets lend the benefit of the doubt to their leadership. Bearish ones simply crush them. BIDU was road kill on Tuesday.

There are other reasons for our conclusions. Recent break outs have failed, a sure sign of a market that is preparing to correct. In fact, we owe readers a mea culpa. In spite of our caution on the market we couldn’t resist recommending two trades on our sister blog on Monday, in TSRA and HMIN. These were fine setups but we knew better. Both promptly failed. The fact that they didn’t work doesn’t mean formation like these aren’t valid. But they require a market uptrend. We were clearly fighting the trend and that’s a loser’s game. We violated O’Neil’s rule about following the market, the M in CAN SLIM. Clearly the “M” is pointing lower.

And we spot yet another divergence on the new highs list. With the major market indices a bit more than 3.5% off their 52 week highs, the 52 week highs list has fallen to about 60 stocks. Contrast this to the last correction on the indices, which reached a depth of better than 5.5% on both major indices on October 2^nd. On that day the 52 week highs list still numbered over 100.

The immediate catalyst to the sell off appears to be a bounce in the oversold US Dollar. This is leading to a sharp pullback in the commodity and energy stocks that had recently moved to the fore. We would expect an oversold market bounce at some point but believe the dollar could well rally further as the market corrects. As we have pointed out numerous times the dollar has been in a pronounced downtrend for the entire duration of the stock market rally. And unless that link is broken the dollar will have to exhaust itself before the market can either resume its uptrend or mount another.

How deep will this correction be? We think you should keep an eye on AAPL, clearly the most liquid and institutionally sponsored of all the leadership stocks. The stock suffered a rare day of distribution Tuesday, pulling back to its 10 MA and dipping into its earnings gap higher from last week. You’ll recall we previously suggested selling AAPL on the violation of its upchannel. The question is how much damage it will endure. The technical signs indicate a bounce is imminent. Watch to gauge the caliber of that bounce. It should be on volume and move price to new highs. If not we’d look for a further correction in both AAPL and the market. If a stock like AAPL succumbs to real selling, not just a meandering journey on non-descript volume to its 50 MA, it could be a lengthy rest for the bulls.