How would one decipher between a healthy pullback and a sustained downturn in the markets?

Science and mathematics are beautiful things because they reflect both the concrete and abstract realities of the universe. The concrete reality is factually explainable and predictable, not subject to guessing. The abstract reality is explainable in hypothetical terms and unpredictable, subject to, at best, educated guessing. The question today reflects the abstract reality of the markets, and so my answer is …  

The first part of my answer is that one primary fundamental of trading is a trader (or investor) needs to understand the big picture. In today’s market, a trader needs to understand the general economic factors that indicate which way the economy is headed on any given day, and, longer term, whether the market believes a sustained economic recovery is in place. This alone might be enough to tell the difference between a healthy pullback and a sustained reversal. Then again, every market is relatively connected to both the larger economic picture, as well as the particular fundamental and/or technical aspects of the market itself and the particular fundamental and/or technical aspects of the trade.    

The second part of my answer is that within both the broad and specific contexts, a trader should look to some key indicators to help ascertain the answer you seek. For example, as I have said many times before, volume is a key indicator that points to momentum and strength. MACD also points to overbought or oversold conditions, which indicates relative strength or weakness in a market. Other indicators can help as well.

Summing up, my answer is not specific because it cannot be without knowing the specific market; however, in general, first look to the big-picture context. Is the overall market fundamentally sound? Has the overall market been reactive or proactive recently? Has the recent market movement been driven by fundamentals, technicals, or emotion?

Next, look to the specific context of the market you are trading. Ask the same questions about this market as you would ask about the overall market. For example, in forex, is the dollar fundamentally strong or is the trade fear-based?

Finally, look to specific indicators to define strength or weakness in a market.

Generally, a trader can define a healthy pullback as a market correcting or coming into trading balance, which means the fundamentals are sound, which means that even if the market is reversing, it probably will not last. At some point, it will find its trading range and take up residence.  Generally, a trader can define a sustained downturn when the big picture is negative, the fundamentals are weak, emotion is at play, or a market is in the midst of a bad news cycle, such as we have seen recently with Toyota and Goldman Sachs.

Trade in the day; invest in your life …                                                                            

Trader Ed