The current market correction has been unusual because of the steepness of its slope. There are few industry sectors that have escaped unscathed and some of the hardest hit are those that performed best over the past several months. The Nasdaq has fallen about 11% from its April peak. But that pales in comparison to the 30% decline experienced by iShares MSCI - Brazil Index Fund (EWZ). I used this fund as an example a couple of weeks ago. It had a three year gain of more than 300%. This is easily the sharpest decline this fund has seen during that period.

The energy sector has also seen double-digit losses in this correction. As an example, Merrill Lynch Oil Sv HOLDRS (OIH) is down about 15%. Precious metals, another leading sector the past few months, has also taken a hit. StreetTRACKS Gold Trust (GLD) has dropped about 10% since peaking a couple of weeks ago.

The big questions most investors have right now are:

• How much longer will the correction last and how much lower will it go?
• How should we be allocated for the biggest gains once the recovery begins?

These are tough questions and unfortunately, the best we can do is make some educated guesses about what is likely to occur. Last week I used a 200-day moving average to show that this is only the fourth time in the past three years that the Nasdaq has dropped below that mark. The other three instances were all followed by strong rallies. That chart below shows the performance of the Nasdaq (black line) and the Dow (gold line) over the past two years. Notice that this correction is steeper than any other experienced during that time. The next most comparable period was July and August of 2004. A correction of similar duration this time would mean we have another couple of weeks before making a bottom.

The bottom portion of the chart is a Moving Average Convergence Divergence (MACD) of the Nasdaq. Notice that the 2004 period was also the last time that the MACD fell to its current level. But a close look reveals a big gap between the blue line and the brown line on the MACD chart. Those lines must come together and cross over when the market turns positive. The wideness of the gap would seem to indicate that we are at least a couple of weeks from that happening.

A word you’ll hear many analysts and market technicians using right now is “oversold.” That essentially means that the market pendulum has swung too far on the side of the sellers. It is like a stretched rubber band or a coiled spring. Eventually the pent up energy is going to swing in the opposite direction. Traders are measuring this condition and are expecting buyers to soon step in and drive the market upward.

As I wrote last week, as an individual investor I would monitor this current market using a 200-day moving average. I would take long positions (buy) when the Nasdaq crosses back above that 200-day MA. Based on the past few instances, I suspect that will occur sometime in June.

Over the past couple of weeks, the only sectors showing gains are those that traditionally gather assets during major market downturns. Government bonds, health care funds and utilities tend to be viewed as defensive positions. When the market corrects, money moves to these sectors. But while these sectors are collecting money now, they will quickly fall out of favor when an upturn begins. Investors will reallocate to other positions in an attempt to get bigger gains.

If this appeared to be a long-term correction–the start of a new bear market–then we would anticipate significant sector rotation as a result of changes in the business cycle. Because this seems to be a correction within a continuing bull market, the sectors that usually perform best on the upswing tend to be those that were strongest before the correction. In this instance that would include international funds, gold funds, and energy funds. In addition, technology funds usually perform well coming off of market bottoms.

Of course, this is just a best guess forecast, not a prediction. There are unforeseen events that could make all of this moot. For example, the next meeting of the Federal Open Market Committee is June 28-29. Another quarter-percent rate hike is anticipated. But if the FOMC were do something unexpected like raise rates by a half percent or announce that rate hikes are over for now, everything would change dramatically.

I’m looking forward to the long Memorial Day weekend. The start of summer has always been a favorite time of year. I plan to do at least a little fishing and my garden is behind schedule. I hope you have a great holiday spending time with friends and loved ones.

The market sell off of the past few days has many investors in a panic when it is probably an occurrence they should welcome with open arms. The Nasdaq has languished for months without a significant move either up or down. This downturn is just setting the stage for the next big upward move offering the next significant profit opportunity.

How bad is the damage so far? Below is a chart of the Nasdaq over the past two years. The red line shows that the index has retreated to the same level where it started the year. It is about 150 points lower than its high for the month–a loss of about 6%. The unique feature of this downturn is its slope. A look back over the two years on this chart shows nothing comparable when it comes to steepness.

The gold line on the chart is a 200-day simple moving average (SMA). Notice that the Nasdaq broke below its 200-day SMA a couple of days ago for only the fourth time in the past two years. On two of those instances, the index stayed below that mark for a short stint. On every occasion, when the index moved back above its 200-day SMA, it posted double-digit gains in a short period. So we should be glad that the index has declined, because it offers us hope that it will soon make an even bigger move to the upside.

Of course, there is no guarantee that this is not the start of a prolonged correction. But with most economic fundamentals still positive, there is no reason to believe this is anything more than an overdue, short-term correction. GDP remains strong, unemployment is low, corporate earnings are generally good, etc. Even the inflation remains low on an annual basis. So while this market move might have been exacerbated by an unexpectedly high monthly Consumer Price Index report, there is not yet evidence of a long-term trend of rising inflation.

The bottom portion of the chart shows a Moving Average Convergence Divergence (MACD). Notice that the blue MACD line is already near the -40 mark. That is lower than the levels reached during the most recent two times when the Nasdaq dropped below its 200-day SMA. That is an additional indication that this correction could reverse quickly.

The blue chip indices have not seen as steep a correction as the Nasdaq. Both the Dow and the S&P 500 are still above their 200-day SMAs. Both are down about 3% from their earlier highs in May.

This downturn in the major market indices is likely to create some changes in sector leadership. For now virtually every sector has corrected along with the major indices, including those that were trending well like energy and internationals. Even gold experienced a significant pullback, something one would not expect if higher inflation is a real threat.

For now, hang tight and watch for stocks to create a bottom. And when the Nasdaq crosses back above that 200-day SMA, be ready to make some money.

Have a great weekend.

The fishing trip to Lake Powell last weekend turned out well. I tried not to think about investing while I was there, but I wasn’t totally successful. I never resorted to checking out current market conditions because I’ve seen too many people who let their moods and emotions be dictated by daily account swings. I rarely take short-term positions, so daily market moves have little impact on my overall investment strategy.

As my son and I walked along the marina between the rows of gigantic houseboats, I could not help noticing that the names of several had investing references. Names like “Winning Portfolio” or “Market Princess” combined with the opulence of the floating mansions left little dobt that the owner experienced some investment successes.

This is really the dream of all investors, isn’t it? We want to buy that special stock, mutual fund, option, etc., that will take off and make us wealthier than we ever imagined. Yet very few investors actually realize that dream. Primarily that is because two of the most difficult choices to make as an investor are when to buy and when to sell. And of those two, selling at the right time is probably much more difficult. Almost every investment will have periods when it makes big gains quickly. Most of us have seen instances where a specific stock goes up 200% or more in just a few days or weeks. We don’t want to sell, because we hope it might be the next Microsoft or IBM and if we sell too soon, we’ll never make enough to buy that fancy houseboat. But most of those stocks that go up quickly come down even faster. If the investor hangs on too long, a 100% gain can quickly become a loss.

I have a friend who is a very successful investor. His philosophy is that any time he buys and investment vehicle, he sets a profit target. In other words, he decided beforehand what a realistic return would be for the position he is taking. That means he does some research ahead of time so he has an understanding about the historical behavior of his chosen vehicle. I can probably explain this better with an illustration.

This is a price chart of iShares MSCI - Brazil Index Fund (EWZ). Over the past three years, this fund is annualizing at a rate of about 110% a year. Most of us would be very happy with that kind of return. The gold line on the chart is the Nasdaq, included just for comparison purposes. The blue line is a 100-day simple moving average of EWZ. That chart shows us that while EWZ has moved up steadily, but there have been some periods of significant drawdowns. These are marked by the red letters.

Someone who purchased this fund in May 2003 would have gained 75% in the first eight months (point A). But over the next six months (point B), more than two-thirds of those gains would have been lost. An investor who bought at point A would have immediately lost 65% of his original investment. The other two downturns shown have not been as prolonged or as severe, but they would still be emotionally wrenching to and investor holding through them. For example, an investor who bought at point C would lose one-third of his investment in the first two months. He would have to hold another four months to make back the money he lost. If he could handle that, then he would almost double his money in the following six months.

Looking at this information gives us some good insight into what to expect if we want to take a position in this fund. First, there will be plenty of volatility. Depending on when we buy, we can expect to start with a fairly significant loss. As long as the fund continues to trend, we can expect good returns. Since 110% a year might not be sustainable, let’s shoot for a profit goal of 75%. We can use the moving average to help us mitigate the possibility or amount of loss and to decide when to buy or sell.

I’ve used green arrows to highlight areas where there are big spreads between the 100-day SMA and the fund price. These usually mark periods where the fund has made a significant advance. We want to avoid buying when that spread is wide, because that increases the likelihood that a correction will soon follow. For example, we would not buy at point A because the spread is wide. We want to buy during periods when the spread narrows. I’ve highlighted those with purple arrows. Buying when the spread narrows does not insure that we won’t experience a loss. If we bought at the first purple arrow after point A, we still would have an immediate loss. But instead of losing 65% from the high at point A we would only experience about half of that loss. You can also see that right now the spread is wide, so we would want to wait for a pullback to buy.

So we buy on a pullback with 75% as our target for profit over the next year. If the fund hits that mark before a year has passed, we probably should consider taking some of our profit off the table then, even if the fund is still trending up. The friend I mentioned above always sells half his position with an investment reaches its target goal. This helps him avoid the dilemma of wondering when to sell. Then he lets the rest ride as long as it trends up.

What if the investment goes against you? In this example, because of the volatility of the fund, we need to be prepared to withstand some significant declines. We’ve seen that we could have experienced a 65% loss at one point. By using technical tools, we should have been able to reduce that by half. So if we are taking a position in this fund, we should realistically expect to be able to handle a drawdown of about 35%.When you consider that in the context of a 300% gain, that doesn’t seem so bad. But actually holding through that type of a dowturn is a gut-wrenching experience.

Today’s market action left us feeling a little of that wooziness. The Nasdaq is still holding above the bottom of the channel that began in January. A move below that support would not necessarily be a bad thing because it would at least allow us to escape from this tight trading range.

We’ll keep our fingers crossed. have a great weekend.

I’m trading one type of channel for another this week. As you read this, I’ll be fishing on Lake Powell in southern Utah. It’s been a long winter and I’m looking forward to the warm desert air, the sunshine and the red rocks. An if we can catch a mess of fish, so much the better.

This will be an abbreviated report, because there isn’t really much new to say. The strongest sectors continue to be energy, gold and select international positions. I’m going to include at the bottom a complete list of exchange traded funds and their performance over the past three months. Scan through them and you will see what I mean. So far there is no indication of a break in that pattern.

When it comes to the U.S. equity markets, major indices continue to trade in relatively tight channels. The Nasdaq is currently at the bottom of its channel, while the S&P 500 and the Dow have not retreated as much and are still trading in the upper ranges of their price channels. I’ve included a chart that shows the Nasdaq as the black line with the S&P 500 (gold line) added for comparison.

I think there are too many market positives for the Nasdaq to break down below support at this time, so I would anticipate a rebound from this level. If that occurs, we are likely to see new multi-year highs for the S&P 500 and the Dow. But they will likely be just slightly higher than previous marks.

I don’t anticipate thinking about the investments markets much at all until next week. I hope your weekend is as enjoyable as mine.