SPX Correction LoomsSubmitted by Michael Nystrom on Mon, 01/24/2011 - 23:33
By: Adam Hamilton | Fri, Jan 21, 2011
The US stock markets have enjoyed an awesome run since late August, with the flagship S&P 500 stock index (SPX) up 23.7%. Traders have earned huge profits in sectors that leverage general-stock-market gains, including commodities stocks. But as usual after any long and uninterrupted rally, complacency reigns supreme today. Such sentiment is a prime breeding ground for spawning corrections.
Nearly all short-term price movements are driven by the collective emotions of traders. When they feel good, they buy stocks. And rising prices eventually lead to greed. When they feel bad, they sell stocks. And falling prices ultimately spark fear. These two emotions are perpetually warring, swinging back and forth like a great pendulum. Greed dominates when prices are up, then fear flares when they are down.
Complacency is a close relative to greed. It is "a feeling of quiet pleasure or security, often while unaware of some potential danger". Like greed, complacency grows when prices are high. The conditions that generate it are long, uninterrupted rallies leading to big gains. After the stock markets rally gradually for months without retreating, the majority of traders start assuming the risk of a selloff has vanished.
But this is always a foolish assumption, as all markets flow and ebb. Bull markets advance forward two steps before retreating one step in their periodic selloffs. Far from being bad, these retreats are extremely beneficial for traders. They rebalance sentiment, bleeding off excessive greed and complacency. This extends the life of the bull market, as it will burn out prematurely if greed sucks in too many traders too quickly. And they drag prices back down, creating the best buying opportunities seen in an ongoing bull...