After months of slumbering complacency, market participants have been awakened by the stark reality of market risks.  What goes up, it seems, can actually come down.  However, we need to put the current market correction in some context given the nearly 30% run in 2013.  From the peak of the market to Wednesday's close, the S&P 500 has fallen by roughly 4%.  If you have been listening to media, you would have likely assumed a much bigger rout had occurred by all of the speculation, hand-wringing and excuse making.  Of course, as investors, what we need to know is whether the current correction will devolve into something much larger.  

I have spent much time recently pointing out the extreme levels of market deviation and valuation elevation.  By these very measures, one should, at some point, expect a much larger mean reversion process in the markets.  However, as John Maynard Keynes discovered after being wiped out in a currency trade gone wrong:

"The markets can remain irrational longer than you can remain solvent."

Therefore, the real trick of investing, and winning the long term investment game, is determining when the "light at the end of the tunnel" is not benign.  While valuations do eventually matter, and matter quite a lot, they are a very poor portfolio risk management tool.  In the short term, it is price which most clearly reflects market sentiment and investor actions.  Therefore, in order to determine whether the current correction is near its end, or signaling a bigger move, we can only really make assumptions based on historical precedents.

Argument For The End Of The Short Term Correction

Last night on the "Lance Roberts Show" I stated that the market was likely to rally rather sharply from Tuesday's closing levels.  This statement was based on the short term oversold condition of the market as shown below. 

The current concern, for me, is the failure of the market to exceed the top set at the beginning of this year.  That "double top" will now present important overhead resistance to any subsequent rally.  However, on a short term basis the market has now sold off to 2-standard deviations below the 50 day moving average.  The market is also defending support at the December lows.

Price movement in the market is somewhat constrained by the laws of physics.  Prices, like stretching a rubber band to its maximum length, can only move so far above/below their longer term moving average before a mean reversion eventually occurs.  These extensions can often last longer than expected but are always resolved eventually.

The chart below is a daily chart of the S&P 500 going back to the beginning of 2008.  The dotted bands represent both 2-standard deviations above, and below, the 50 day moving average.  As you will notice, in bearish trending markets (2008) the market tends to trade between the 50 dma and the lower standard deviation band.  In bull markets, prices tend to remain between the 50 dma and the upper standard deviation band. 

However, prices tend to stay confined between the upper and lower standard deviation bands over short term periods.  I have also noted the upper trend line resistance that has been in place since the 2009 lows along with the original trend line support.  The market changed from a bullish to bearish trend in 2011 during the debt ceiling debate as a much deeper correction was in the making.  However, monetary interventions by the Federal Reserve halted the sell off and started a subsequent market rally that has remain confined by the original trend line support which has now become overhead price resistance.

The bottom part of the chart above is a relative strength index (RSI).  I have drawn vertical dashed lines from the lows in the relative strength index to the lows of the S&P 500 index.  Currently, the RSI is at levels that are normally consistent with short term bottoms.

It is very likely that the recent selloff has reached a short term bottom.  A rally back to the 50 dma, or an attempt at previous market highs, is entirely possible.

Longer Term Concern

As an investment manager, my primary goal is to stay allocated with the market as long as the market is in a positive, or upward sloping, trend.  However, it is also my job to reduce portfolio risk when that upward bias is broken.  Therefore, I am much more interested in weekly data analysis which smoothes out the day to day "noise"  of market volatility.  As you will notice in the chart above, there are numerous signals over the course of the last few years which would have substantially increased portfolio turnover.  However, by smoothing the data, as shown in the chart below, the number of portfolio actions is reduced.

As with the previous chart above, the weekly price data of the S&P 500 is banded by 2-standard deviations.  As I stated previously, and more clearly shown here, is that during bullish trending markets prices trade between the moving average (50-weeks in this case) and the upper 2-standard deviation constraint.  It also remains the same in bearish trending markets. 

One thing to notice in particular is that beginning towards the end of 2013 the market broke above the upper standard deviation band rather substantially.  This is the only time this has happened during the recent bull market and is a sign of the more "irrational exuberance" that took place.

With the exception of the 2013 liquidity driven rally (courtesy of the Federal Reserve's $85 billion per month), the market has generally corrected back to the 50-week moving average during the course of the current cyclical bull market.  The current excess deviation above the long term moving average suggests that the current correction may indeed have more to go to be complete.

That thought is further supported by the lower weekly RSI which has only completed roughly 50% of a normal market reversion process.

Failure To Breakout

While the current sharp reflex rally from oversold conditions in the market was expected, it will be important for the market to breakout above the "double top" shown in the first chart above.  A failure to do so will likely mean that a further correction process is in the works.  The final chart below shows the current percent deviation of the market above the 50 week moving average.  Normally corrections either revert to, or beyond, the long term moving average.  Currently the market remains 5.61% above the long term mean but has been reduced from recent extremes.

With the Federal Reserve now extracting liquidity from the financial markets, it is conceivable that the recent correction was the beginning of a longer term consolidation/correction process from recent extremes.   As discussed recently in "2014 A Bull Year?:"

"Could we have another bullish year in 2014?  It is certainly possible as long as the Federal Reserve remains engaged in their ongoing balance sheet expansions. 

But maybe the ongoing inflation of assets, without the underlying improvement in organic, sustainable, economic growth, will eventually lead to the next market bubble and bust. Of course, for anyone that has paid attention, such an outcome would be of little surprise.

The important point is that, as an investor, you need to pay attention to the ever decreasing reward/risk ratio of chasing the financial markets. The 'low hanging fruit' has long been harvested and the risk currently far outweighs the potential reward of being aggressively invested."

There is one thing that is crucially important to remember - "we are all guessing."  While there are plenty of individuals currently prognosticating that the current bull market is still intact, and could indeed be proven right, they are only making an educated guess.  However, it is also important to remember that most of these individuals on television have an inherent bias to sell you some product or service which keeps your money invested at all times for a fee.   As I discussed recently in "The Truth About Wall Street Analysts:"

"While individuals believed that Wall Street was out to take care of them the real truth was markedly different.  Wall Street got rich while they got poorer."

I can only guess at the moment whether this short term correction is over.  However, what I am quite sure of is that a much larger reversion in the market awaits us in the future.  What will trigger that reversion will likely be something that is not even on the radar as of yet.  Or, maybe it will just be the lack of the liquidity push by the Federal Reserve.  Whatever the reason, it will be important that you manage the inherent risk in your portfolio because there will be no one from Wall Street telling you it is time to leave the casino.