Trader on phone NYSE

While there are many issues weighing on the minds of investors these days including what the Fed is going to do next (and more importantly, when they are going to do it), the state of China’s economy/stock market (last night’s data wasn’t good), and whether or not the bear market in commodities is the tail wagging the dog, perhaps the biggest question at this stage of the game is if we’ve seen the worst of the correction in the stock market.

To be sure, there is no way to know the answer to the latter question without a healthy dose of hindsight. However, given that (a) Ms. Market appears to be wearing her “waterfall decline” costume right now and (b) these moves tend to follow a similar pattern, we do have some idea as to what to expect next. And as I wrote last week, the odds would seem to favor stocks being in the “bottoming phase” at this time.

I saw some additional research on the subject last week from Ned Davis Research where Ned Davis himself compared the price action and the volatility levels of the global stock market’s dive to past waterfall declines on a global basis. Once again, the “nearest neighbor” to what we’ve seen in the stock market since the middle of August appears to be the 2011 decline, which many deemed to be a “mini bear market.”

So, if stocks continues to mirror the 2011 decline, we can expect to see (a) volatility stay very high for the next couple of months, (b) a lower low on the major indices, and (c) a traditional year-end rally, which tends to make everyone feel better by the time New Year’s Eve rolls around.

However, there may be a fly in the ointment here.

Something has been bothering me for quite some time and the action in the coming weeks/months may tell me whether or not my concerns are justified.

Does It Matter?

Cutting to the chase, I question whether the August decline was a corrective phase in the traditional sense or simply another bout of high speed trading gone wild.

More specifically, the combination of this year’s long, sideways consolidation phase and then the ensuing dance to the downside in August has done a fair amount of what used to be called “technical damage.” Since May, we’ve seen all kinds of longer-term indicators waive yellow warning flags, which in the past has meant that all was not right with the world.

To be clear, we’re not talking about a couple indicators. No, we’re talking about all sorts of indicators, looking at all kinds of things in the stock market game. For example, the volume relationship indicator is negative. The leading indicators model is negative. The risk-reward model is negative. And my “desert island” indicator is a whisker away from turning negative as well.

But the question is, does it matter? With markets now moving 10% (in both directions) within a matter of days, are these time-tested indicators still as meaningful as they were in the past? Or has the algo-driven, millisecond trading environment changed the game completely?

A Two Handed Argument

On one hand, I can argue that the new, new normal (where trading machines dominate the stock market) will wind up causing a great many indicators to be “fooled” as the algos have displayed a distinct tendency to chase their tails in one direction for a matter of days and then simply reverse and go the other way when the mood strikes.

Yet on the other hand, the sheer number of indicators that have issued warnings this summer is worrisome. And while the indicators do not suggest that another severe decline, such as we saw in 2000 or 2008, is on the horizon, the history of these indicators tells us that caution is definitely warranted and that the current corrective phase may not be over.

So which is it? Will Wall Street’s mad scientists wind up fooling everyone and everything as they “play” with the market indices on a daily basis? Or will the market succumb to a more meaningful decline, as the indicators seem to be warning?

Honestly, I don’t know the answer to this question. But sometimes understanding the question is half the battle, right? So, I for one will be watching the action in the coming days/weeks more closely than normal. If the market breaks down from here and the price discovery phase begins anew, then I can breathe a sigh of relief and rest assured that the time-tested models and indicators are still worthy of my attention.

However, if this decline winds up reversing quickly and then merrily bouncing up to new highs, then we may have to start asking some difficult questions about the effectiveness of many indicators.

From a near-term perspective, the current dilemma can be easily seen on the chart of the S&P 500. The index is clearly coming to an important juncture from a technical standpoint.

S&P 500 – Daily

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In case the situation on the charts isn’t obvious, the opposing trendlines represent each team’s important lines in the sand. A break above the downtrend line that began in mid-August would likely give the bulls a boost while a break below the rising trendline could be a harbinger of more weakness ahead.

In closing, I recognize that this missive raises more questions than it answers. Please accept my apologies if this causes confusion. But the key point I’m trying to make is that the character of the market may be changing. And the key to surviving these inevitable changes over time is to keep an open mind and not to become entrenched in a single investing methodology. Therefore, asking questions and keeping your eyes open may be one of the most important aspects of this game we call the stock market.