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The big question going forward is whether January’s decline in the S&P 500 is a correction or the start of a new trend to the downside.

Short view: It’s a correction that will max-out at 10%, if it even goes that far.

First, there really is no such thing as the “January effect,” which is the idea that January leads the way for the overall year’s performance. There’s no statistical basis to support this and anyway, stocks gained about 34% in 2009 (and about 65% from the March 2009 lows) despite the 9.5% decline in January 2009.

Second, in normal up years, there is an average of three, 5% corrections and one, 10% correction.

Third, and most important, there’s no reason for stocks to be starting a new down trend other than on speculation that the withdrawal of fiscal and monetary stimulus will cause a second wave of economic decline in the second half of 2010.

The scorecard for corporations reporting profits during Q4 is that nearly 80% have beaten the estimates for earnings and that over 50% have beaten the top-line estimates for revenue growth.  Additionally, the first estimate of 4^th quarter GDP, widely expected to get an enormous boost from inventory re-stocking, actually did better than expected on several fronts.

In real (inflation adjusted) terms, overall spending slowed to a  2% pace (from 2.8% the previous quarter) after the cash-for-clunkers plan expired but excluding autos, consumer spending increased at a 3% annualized rate, the most in three years. Significantly, the boost in spending ex-autos was supported by incomes rising at a 4% pace, the most since Q2 2008, and from the 2.2% growth in wages and salaries, the best performance in two years.

Allow me to go back to the idea that investors will discount future value based on the withdrawal of fiscal and monetary stimulus. The Obama administration is now focused on jobs (as well they should have been since day 1) and will concentrate their efforts in that direction, For example, they can re-start cash-for clunkers (actually, they can start cash-for-anything programs) and can always extend the tax credit for homebuyers. Second, the Federal Reserve will absolutely jump back in to support growth if necessary, which is what they’ve repeatedly promised to do in their recent statements.

In my opinion, stocks could be somewhat more than half-way through a correction that is likely to max-out at about 10%. Let me explain.

I’m using a Fibonacci sequence to measure the retracement of the decline in the S&P from the time that Lehman Bros. collapsed in Sept 2008 to the March 2009 lows. The last high was made nearly exactly at the 80.9 level, meaning that 80.9% of the collapse after Lehman Bros. had been made back before the latest correction began.

Now, here’s the best part:

A 10% correction from the 80.9 fib level would put the S&P at about 1036, nearly exactly at the 61.8 retrace level, which is where the market last found a major level of support back in November!

I will say this however:

Stocks could just very well turn around from here, especially if the numerous Purchasing Manager Indexes from all over the world (including China) turn out better than expected next week (as I believe they will).  And all of that will be further supported if the NFP, scheduled for release next Friday, turns out better than expected (which is hard to estimate in advance).

On the other hand, we’re seeing stocks decline even though many economic and corporate earnings reports have beaten expectations, so it wouldn’t be surprising to see price move towards that 61.8 retracement level. But unless these reports turn out to be very disappointing, which I do not expect to see happen, the present correction is likely to max-out at 10%.

About Me
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The big question going forward is whether January’s decline in the S&P 500 is a correction or the start of a new trend to the downside.

Short view: It’s a correction that will max-out at 10%, if it even goes that far.

First, there really is no such thing as the “January effect,” which is the idea that January leads the way for the overall year’s performance. There’s no statistical basis to support this and anyway, stocks gained about 34% in 2009 (and about 65% from the March 2009 lows) despite the 9.5% decline in January 2009.

Second, in normal up years, there is an average of three, 5% corrections and one, 10% correction.

Third, and most important, there’s no reason for stocks to be starting a new down trend other than on speculation that the withdrawal of fiscal and monetary stimulus will cause a second wave of economic decline in the second half of 2010.

The scorecard for corporations reporting profits during Q4 is that nearly 80% have beaten the estimates for earnings and that over 50% have beaten the top-line estimates for revenue growth.  Additionally, the first estimate of 4^th quarter GDP, widely expected to get an enormous boost from inventory re-stocking, actually did better than expected on several fronts.

In real (inflation adjusted) terms, overall spending slowed to a  2% pace (from 2.8% the previous quarter) after the cash-for-clunkers plan expired but excluding autos, consumer spending increased at a 3% annualized rate, the most in three years. Significantly, the boost in spending ex-autos was supported by incomes rising at a 4% pace, the most since Q2 2008, and from the 2.2% growth in wages and salaries, the best performance in two years.

Allow me to go back to the idea that investors will discount future value based on the withdrawal of fiscal and monetary stimulus. The Obama administration is now focused on jobs (as well they should have been since day 1) and will concentrate their efforts in that direction, For example, they can re-start cash-for clunkers (actually, they can start cash-for-anything programs) and can always extend the tax credit for homebuyers. Second, the Federal Reserve will absolutely jump back in to support growth if necessary, which is what they’ve repeatedly promised to do in their recent statements.

In my opinion, stocks could be somewhat more than half-way through a correction that is likely to max-out at about 10%. Let me explain.

I’m using a Fibonacci sequence to measure the retracement of the decline in the S&P from the time that Lehman Bros. collapsed in Sept 2008 to the March 2009 lows. The last high was made nearly exactly at the 80.9 level, meaning that 80.9% of the collapse after Lehman Bros. had been made back before the latest correction began.

Now, here’s the best part:

A 10% correction from the 80.9 fib level would put the S&P at about 1036, nearly exactly at the 61.8 retrace level, which is where the market last found a major level of support back in November!

I will say this however:

Stocks could just very well turn around from here, especially if the numerous Purchasing Manager Indexes from all over the world (including China) turn out better than expected next week (as I believe they will).  And all of that will be further supported if the NFP, scheduled for release next Friday, turns out better than expected (which is hard to estimate in advance).

On the other hand, we’re seeing stocks decline even though many economic and corporate earnings reports have beaten expectations, so it wouldn’t be surprising to see price move towards that 61.8 retracement level. But unless these reports turn out to be very disappointing, which I do not expect to see happen, the present correction is likely to max-out at 10%.

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EURUSD Forecast:
The EURUSD was closed higher at 1.4139 on Friday. I still prefer a bearish scenario but the rejection to move below 1.4030/00 support area could trigger further upside correction testing 1.4200 – 1.4250 at this phase. As you can see on my h4 chart below, we have a minor bearish channel (aqua) indicating that technically we are still in bearish view. A violation to that minor bearish channel and a break above 1.4250 key resistance level should be seen as serious threat to the bearish outlook, testing 1.4450 and the major bearish channel (red). Immediate support at 1.4110 area. Break below that area should trigger further downside pressure testing key support 14030/00 area.

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1. No matter how complex things may seem, it still comes down to supply and demand.

The price of money is determined the same way that the price of anything else is determined; the law of supply and demand. Basically, if demand for something rises without a corresponding increase in the supply, its price will naturally rise. And if the supply of something shrinks while the demand stays constant or grows, its price will naturally go up. The trick in forex is understanding when the supply and demand equation will be rebalanced by the market. Here’s an example:

When Fed Chairman Bernanke announced on national television that the Fed was “electronically” printing dollars, it naturally meant that supply was increasing (or that the market was going to perceive that supply was increasing).  From that point forward (mid-March), the dollar depreciated against nearly all currencies until about the beginning of December.

Likewise, if and when the Fed announces its intention to begin draining the tremendous amount of reserves it created during the liquidity crisis, the market will perceive that supply is going to shrink and that will naturally cause the price of the dollar to rise.

Now, the type of movement I’m describing here is something you see on the daily charts over weeks and months and has nothing to do with the little bleeps and blips seen on miniscule time frames. In fact, the movement seen on 5, 15, 30 etc. minute charts has, for the most part, little to do with the law of supply and demand. For the most part, movement on these charts is driven by things like bank positioning, profit taking (or loss prevention of previous trades) by major players like hedge funds and investment banks, and the wiping out by big players of smaller player’s positions.

2. Adjust position size according to where your stop must go.

If you wanted to sell something for say $10.00 and you knew there was a lot of demand at say $9.50, would you lower the price? Chances are that you would, especially if you saw a lot of orders clustered around $9.50 and few at $10.00. Of course, retail forex traders can’t see where orders are clustered (as banks can) but what we can see is where demand has been recently. So, wherever it is that demand has been seen not too long ago must be the place where your stop has to be placed. The simple rule is that you don’t want to be stopped out of a long trade where you have seen buyers recently in the market. Here’s an example:

Let’s say EUR/USD is currently 1.4275 and you want to go long. Let’s also say that you’ve seen demand (a.k.a. support) around 1.4200. You cannot get into this trade with a 25 pip stop because if you do, you leave yourself open to the possibility that banks will lower the price because they want to pick up additional orders at 1.4200.

Now, in order to hold this rather large stop, you’ll probably need to decrease the amount of lots you’re trading because a good rule of thumb is to not risk more than around 2% of your account on any one trade. In the above example, if 1 mini = a $1 position (assuming 100:1 leverage) and you have to risk $75 (which you have to do because you can’t allow yourself to get stopped out where you know demand is), you need to have at least $3750 in your account to take this trade with a maximum loss of around 2% of your account ($75/.02 = $3750). If you don’t have that amount in your account than just skip the trade.

Likewise, if you have say $6875 in your account than the maximum amount you should risk on this trade is $6875 x .02 or $137.50. In terms of lot size, $137.50/75 = 1.8 minis (rounded to 2 minis or a risk of 2.2%).

Of course, there’s another alternative which smart “shoppers” often look for. Why not try and wait for price to drop to the area where demand has been seen? At that point, you probably won’t need nearly as big a stop. Everyone wishes they could trade with the smart money so if the smart money is in the market at 1.4200, don’t you want to be in at that price too?

Look at it this way. You’re willing to make a bet that price will rise after you buy at 1.4275. Why not wait to buy where you know price has risen from before?