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Setup For A Correction?



Today we are seeing volatility return to the market. As I write, the S&P 500 and Dow are down 2.08% and 2.39% respectively. Over the past week the VIX has risen over 40%, coming off of a period of historically low closes. While today is exciting, the real story will be told when the markets re-open on Monday.

The setup today feels like a familiar story in this historic bull-run. An unforeseen political action, in this case the release of the GOP Surveillance memo, followed by a subsequent decline in the markets. Historically, shares have shown to be resilient; recovery from the surprise Brexit vote took less than 2 weeks for the S&P 500.  The term ‘buy the dip’ has come to characterize our current market. Moving towards the close today and during the open on Monday we will see if the sentiment for buying these pullbacks has shifted.

Over the past week I have read second hand reports of brokers having difficulty selling volume in the market. In other words, stocks appeared to be trading rather thin, with large sell orders easily causing price declines. I am wondering whether this thin market and lofty valuations, combined with the spark of the released memo could be the catalyst to upset the bull-run we have seen, leading to a correction. 

With the phenomenal returns that investors have benefitted from over the past several years, the downturn today may be enough to ring the bell and have investors take some equity risk exposure off the table. Even if they do not ultimately sell shares, it may be enough of a wake up call for individuals to set stop loss orders in case the market decides to continue further downward. If the ‘buy the dip sentiment’ is in fact overcome with a newfound risk-off attitude, the market could be overwhelmed on Monday. A potential build-up of sell orders in a thinly traded market could cause another precipitous decline, triggering stop loss orders from investors who were scared just enough. As I mentioned, I believe that what the market does going into close will be indicative of what will happen on Monday, and as of 3:00 we are currently seeing weakness going into the close.

The unwind I describe above is not a novel concept and is was seen to an extreme degree on the infamous Black Monday. I am not projecting another 22% decline in the Dow, but am acknowledging that we are seeing some of the same building blocks that led to Black Monday. The saying is that history doesn’t repeat, but it sure does rhyme. I would not be surprised to see the market pullback to an even greater degree on Monday, leading to a full correction next week.

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