Correction in Progress, Proceed with Caution

Last Thursday, I described the current pullback as destined to become a text-book “10%” correction. I also said the first bounce would come above 1,040 on the S&P 500 Index (SPX), as equity fund managers would start scooping up what they saw as bargains. The low on the SPX on Friday was 1,044.

Here’s a look at the current chart and then a few reasons why this correction ain’t over.

In addition to the three “fulcrums” I outlined in last week’s article: China Slowdown, Sovereign Debt, and Perfect Future (stocks priced for best case 2010 earnings), here are two more things to keep in mind:

4) Bearish Sentiment. By this I don’t mean we’ve seen an excess of it. I mean it has only just begun. A little fear in this market is in order with all the uncertainty in the first three themes. In short (pardon the pun), the sellers have the upper hand right here and portfolio managers will “wait and see” how bad it gets before they put too much of their cash to work. A test of last week’s low is a high-probability bet, and a touch of my support levels on the chart in the 1,020-1,030 band is a “50 delta” (50% chance).

5) The Flush. This market will turn and go higher after a fear-driven exit from risk assets peaks and takes out the weak hands. That could be accompanied by a VIX spike above 30, and continued pressure on crude oil, gold, and the euro currency. Maybe that takes us down to S&P 1,000, or even the 50-week moving average at 985. But it will likely happen in one day and the violent bullish reversal won’t give you a chance to think about it, let alone to buy a close down there.

The overall strategy then for this market correction is to have at hand your watch list of favorite stocks you want to buy on sale, and then be ready with low-ball limit orders. Whatever your criteria, oversold momentum/growth/sector leaders  or attractive forward multiples, you won’t get a second chance to buy those names at 20-40% off their highs in the next month.

Bottom line: Be cautious about the broad market now, and be ready to pull the trigger on growth and value leaders on the flush. And, as always, be sure to…

“Mind the Risk, Bank the Profits!”