Strong Market Trends Don’t Die Quickly

We believe the highest odds favor a pullback between 2.5% to 5.5% on the S&P 500 relatively soon, with the second most likely range being 5.5% to 11.1%. One reason for the relatively tame correction expectations has to do with the strength of current trends.

On February 20, we noted the black ADX line for the NASDAQ was above both the green and red lines (directional lines), and presented the text below from Trading For A Living:

When ADX (black line) rallies above both directional lines (red & green), it identifies an overheated market. When ADX turns down from above both directional lines (red & green), it shows the major trend has stumbled. It is a good time to take profits or partial profits.

There are numerous markets and ETFs with extended ADX profiles, including the S&P 500 Growth Shares ETF (symbol IVW). The ADX reading we have today (see point A1) is similar to the ADX reading from early 2004 (point A). The high level of ADX reflects a strong trend. The lesson from 2004 is we may see a very brief and shallow pullback, followed by some relatively tame gains. Due to the strength of the current trend, a period of consolidation (a few weeks) may be required before any significant correction takes place (see 2003-2004 scenario below).

It is possible the market does very little in terms of gains and losses over the coming weeks. However, we need to see what happens next. The main takeaway is the odds are relatively low we are nearing a major top and/or sharp reversal. A sharp correction is most likely in the cards over the coming weeks, but it may take time to develop (see right side of 2003-2004 chart).