Market Comeback Unlikely to Forestall Further Downside

The market was slightly lower yesterday on some mild distribution. While we do not see distribution as a problem for the rally at this point that doesn’t mean the correction cannot deepen.

After opening higher the market sold off hard upon the release of the Chicago PMI. Last month this very report was the first solid evidence that the recession had ended as the index hit the 50 point, which demarcates growth from contraction. With expectations of a 52 reading the market was stunned when the report decreased to 46.1.

Economic recovery is not a smooth affair and the market, at the precipice of a severe sell off, came to its senses and righted itself into midday. While that was impressive the late day decline indicates that the correction likely has further to run. Bear in mind there’s been no significant follow through to Monday’s low volume expansion bar off the pullback. While the market climbed back to a certain degree the fact remains it ended lower on volume and began a second pullback off the highs without making a new high.

Importantly, during the most recent upleg of the rally the market ignored any bad news and seized on factors that indicated a return to growth to push its way relentlessly higher. But since the recent peak on 9/23 the market is focused on negative economic news and of late there has been a parade of it. And opportunities to focus on the negative abound ahead of us with the ISM index out later this morning and the employment report on Friday.

Plus we are in earnings warning season. Ultimately it is corporate earnings that define when a recession can reliably said to be ending and we remain three weeks away from any lift these reports can give. In the meantime the market, given its current wont, is likely to seize on any high profile warning as a reason to slap investors.

We still believe the rally has further to go given the way leading stocks continue to hold up well and even make new highs, but that the market is likely to continue trading in ragged fashion for the next few weeks, testing the mettle of traders. However long the volatility endures, until the rally can firmly reestablish itself caution is warranted in initiating fresh positions. And unless you have a sufficient cushion in your core longs, tight stops are recommended.