Is a Major Stock Market Correction Coming?

As the U.S. economy continues to show signs of improvement, Greece weighs down the world and threatens significant problems that could reverberate around the globe. “Big Ben” Bernanke of the Federal Reserve and “Super Mario” Draghi of the European Central Bank continue to pump enormous amounts of liquidity and “free money” into global financial systems in an attempt to keep markets afloat, but like the epic struggle between the Titanic and the iceberg, the current situation looks more and more like the iceberg is winning.

And while the fundamentals are troubling, to say the least, the technical indicators are positively terrifying.

Click to EnlargeIn this chart of the movements of the S&P 500 (at right, courtesy of www.stockcharts.com), we see a graphic display of the overbought condition of the RSI (relative strength indicator). The RSI is now well above 70, which is widely viewed as the “red zone.” We can see how the S&P 500 has reacted with measurable declines at previous points in history when the RSI was at levels similar to those of today. Furthermore, the index is currently at significant resistance, a level that adds additional weight to the thesis that a major correction could be just around the corner.

Click to EnlargeA quick glance at the VIX (at right, chart courtesy of www.stockcharts.com), the CBOE “fear indicator” shows complacency running high — so high, in fact, that the VIX is now reaching multiyear lows that have not been penetrated since back in the good ol’ days of 2007, which seems like almost a lifetime ago.

A look at RSI shows us that the VIX is very oversold and therefore ready for at least a short-term rebound to higher prices of the indicator.

The significance of the VIX is that declining readings in the VIX typically portend higher stock prices, while rising readings typically precede lower stock prices. With the VIX at multiyear support levels and highly oversold, the possibility of a directional reversal is high.

Putting the two charts together, one can only come to the conclusion that a significant and measurable stock market correction is probably imminent. Of course, timing it tricky, but somewhere in the near future one could expect such a correction to occur.

For ETF investors, now could be a good time to pick up some protection via put options on positions you want to keep, moving a portion of your assets to cash or even deploying a couple of strategic inverse exchange-traded funds if you’re an aggressive investor.

At Wall Street Sector Selector[1], we are currently positioned in cash in anticipation of a change in market direction. With Greece in doubt and Portugal right behind it, fundamentals also support the probability of lower ETF equity prices ahead. It’s unlikely, though possible, that we’re heading for another brutal bear market.

If this is just a normal correction, then over the next few weeks we could see some excellent buying opportunities. If it’s something more than a garden-variety correction, defensive moves now could position an investor to take advantage of the opportunities that will emerge should the bear raise its fearsome head again.