The S&P 500 Index, after stalling below resistance for much of May, has now slipped below its lower channel line and is testing price support again at the 875 level. If the 875 level is violated the market will become more defensive and expect selling to materialize quickly as traders will look to lock in remaining profits from this rally.
At this point we do believe any selling that materializes on a breaking of the aforementioned support zone would be fairly short-lived and the price drop relatively shallow (10 – 15%). We further believe if this selling occurs it will be part of a market retesting phase and would set up another buying opportunity since there isn’t a lot of supply left after the near eight months of continuous selling from August 2008 into the March 2009 low.
Additionally, momentum indicators such as the 21-day Rate of Change (ROC) are seeing the rate at which prices are accelerating slow rapidly when compared with the aggressive pace of acceleration seen in the beginning of the advance. This divergence between price and momentum can typically be a warning sign that a near-term trend change will take place.
Since we don’t believe this will be a large sell-off, investors can play this potential corrective wave several ways: firstly, tighten trailing stops on profitable positions or offset long exposure by shorting an equal dollar amount to your long exposure of a market ETF or buying an inverse market ETF; secondly, sell all remaining long exposure and wait for a pullback to repurchase names at cheaper prices, or lastly, and for only the most aggressive investors, sell all long exposure on a support level break and increase short exposure significantly by shorting a market ETF or buying an inverse market ETF (in this option keep stops and drawdown limits tight).
Source: Kevin Lane, Fusion IQ, May 14, 2009.