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It can be very daunting, investing or trading a market when it falls off a cliff. No one wants to catch a falling knife. But also, a pullback or a correction in the market can present an opportunity to go shopping and purchase shares at a discount.

A pullback, (a.k.a retracement, counter-trend) in an uptrend is when a security forms a peak and pulls back. Once it comes back to the uptrend line, it reverses and goes on to create a higher peak. Therefore pull backs are a typical function of an uptrend, actually a strengthening of them, and considered normal and healthy for a rising stock.

Example of a Pullback / Retracement

A pull back typically doesn’t change the underlying trend. They are usually a profit-taking opportunity following a strong run-up in a security’s price. If nothing has changed fundamentally then this can present a great time to go shopping and accumulate.

Correction

With a correction we need to be careful as the stock or index could take a much larger fall compared to a pull back or retracement. A correction is usually 10% or more and generally happens very quickly, sending volatility levels soaring. Often a correction will break the current trend, but will quickly find buying support again and recover.

A correction can also be a buying opportunity, but you need to be careful as volatility is usually high and prices are moving quickly. Predicting the bottom of a correction also can be difficult. You should always check your fundamental view also before buying, to avoid buying into the start of a down trending market.

Bear market (down trending market)

A bearish trend is when the peaks and troughs are overall going lower and will generally last over a longer period. Good examples of bear markets are in 2015 – 2016 where we fell 21% over a year period. Or the GFC which the market fell around 55% in a year and a half.

The 2015 bear market was partly caused after APRA announced that the banks had to hold more capital to cover their loan books. The banks went to the market to raise the capital, diluting their share value and seeing further selloffs. Also, at the same time we saw commodities like Crude Oil and Iron Ore plummet. This saw both the two major indices leading the falls.

XJO (Top 200) Index Weekly Chart.

So, is our market having a pull back, a correction, or is the start of a bear market?

The two targets we had for a pullback have broken:

First was 6075 which was the 200-day moving average, that also had strong support and resistance close by at 6,100.

Second was around 6,000 which was the long-term uptrend line and a key level of support for our market.

XJO (Top 200) Index Daily Chart.

Now that both pull back levels have broken, the questions remains, is this a correction or the start of a down trending market? Obviously, there is no way to answer this with any certainty, but let’s weigh up what we know. At this point of time the XJO has found some support at 5,800 which is one of the Fibonacci Retracements.

We have our first lower peak and two lower troughs, so we are on the verge of forming a downtrend. Technically, in fact we have a short term down trend, but need more evidence to see if we are going to form a broader and longer term one.

XJO (Top 200) Index Daily Chart.

A break of 5,740 is the next confirmation level, which is a 10% correction from this year’s highs. It will also give us the next lower trough on a weekly chart. From there, the only two levels of defence is the nearby 5,650 which is a key support from 2017 and 5,500.

XJO (Top 200) Index Weekly Chart.

Also, let’s look at the broader picture. The sell down is mainly from fear and uncertainty, more so than weak economic data or company reporting. The forward out look for the global economy is uncertain, as it is hard to predict how bad the trade war will get between the US and China. Add increasing interest rates in the US, a cooling housing market locally, the Royal Commission locally and things continue to become more and more uncertain.

But on the other hand, we have strong economic indicators by the way of very low unemployment both here and in the US, stable inflation levels, and strong GDP growth. Commodities in general are faring well and interest rates from an RBA point of view are still accommodative. The Aussie dollar weakening is helping many exporting companies.

So, at this stage this is more of a fear sell off and if nothing else escalates with the US and China, and the US has a strong reporting season, this will likely be just a correction.

Not to mention that the US markets are yet to show signs of a down trend and are just having a pullback (at this stage).

My opinion would be to keep a look out for weakening economic data around the world, US company reporting, and commodities prices. Then Technically the three next key levels on the XJO 5,740, 5,650 and 5,500. If 5,800 holds in the coming week we will likely rebound back near 6,150 in the next 4-6 weeks.

Tomorrow night the co-founder of TradersCircle, Carlo Castellano, will be conducting a webinar to discuss his current view of the market and to show the techniques that we use to pick the market direction. The session starts at 7pm AEDT click here to register your spot.