Double-digit downer days of this magnitude are rare on Wall Street. They're virtually impossible to predict and tough to defend against.
It also doesn't make much sense to try to sidestep stock pullbacks of 5% to 10%, as they occur fairly regularly and are difficult to time.
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But trying to avoid the bulk of the financial pain caused by slower-moving stock market horror shows, such as the 57% drop in the 2007-2009 bear, is worth the effort. And with the stock market suffering six straight weeks of declines and down as much as 7.2% from its late-April high, it's a good time to reassess the market's longer-term health.
Red flags, which hint at or foreshadow impending doom, do pop up from time to time. The key is recognizing them — and adjusting your portfolio and risk level to preserve capital.
In retrospect, for example, the failure of big Wall Street firms such as Lehman Bros., the blind optimism that home prices would never stop going up, and the need for Uncle Sam to bail out U.S. banks, insurers and automakers during the recent financial crisis should have been enough evidence to persuade folks to sell some stock to limit their losses.
The tough part, of course, is knowing what warning signs to look for when trying to identify a major trend change in the stock market.
Wall Street, however, is always scanning the tape, the charts, the economic data, the mood of investors and news headlines for signs of a market top.
Currently, the stock market is selling at roughly 13 times 2011 profit estimates, below the average P-E of 15, and isn't flashing a warning. Investor euphoria, which often appears at market tops, is also missing. Other bull market killers, such as a sharp rise in interest rates or a rapid jump in inflation are also absent, at least for now.
Here's a Wall Street 101 version of what the pros are watching for now to help them determine if the 27-month bull market is nearing an end and how investors can avoid falling over the proverbial stock market cliff.
•Economic relapse. If the economy, which has been in growth mode since the end of the recession in June 2009, shows signs of lapsing into another recession, it's likely the stock market will suffer a reversal and turn sharply lower, says James Paulsen, chief investment strategist at Wells Capital Management.
Keep an eye on incoming economic data to see if the recent patch of weak data related to jobs, manufacturing, retail sales and consumer confidence continues to slide. For now, the economic growth has slowed but is still positive. GDP was a bit below 2% in the first quarter of 2011. But if there are signs that the end of the economic cycle is near, reduce risk. "The end of a cycle, you have to get it right," says Paulsen.
•Lower lows. If major stock indexes such as the Standard & Poor's 500 and Dow start carving out a pattern of lower lows and lower highs, it could suggest market momentum has been lost. If the market falls below previous key lows, such as the S&P 500's intraday low of about 1250 in March, when selling intensified due to Japan's nuclear accident, it could presage steeper losses to come, says Bruce Bittles, investment strategist at Baird. "If selling took out 1250 on the S&P 500, it would suggest a change in character for the market," says Bittles. (Friday's S&P close: 1271.50.)
•Risk-off trade. Sure, earnings drive the market, but the market is really driven by risk taking, says Chris Johnson, CEO and chief investment strategist at Johnson Research Group. If investors go from a risk-on to a risk-off mentality, be wary, he says.
"Individual investors need to watch to see if investors are looking for opportunities to make money by taking risk, or if they are falling back into a shell," says Johnson. "If investors are moving toward a defensive posture, it is an indication that they are pulling money out of the stock market."
An easy way to determine if the risk trade is off is to watch the performance of the riskier small-cap Russell 2000 index vs. the steadier blue-chip Dow, says Johnson. Since the April 29 high, the Russell 2000 is down 9.5%, vs a drop of just 6.2% for the Dow.
•A trend change. If a broad index of stocks, such as the S&P 500, falls below its average price established over a long period, it's a sign the up trend has been broken and a new down trend established, says Todd Salamone, senior vice president of research at Schaeffer's Investment Research. He likes to use a 20-month moving average for the S&P 500, which is roughly 1186 now. If the index falls below its long-term trend line, that's a potential sign of a major turn for the market. "The 20-month average price has been a decent roadmap," says Salamone. "And cross unders have been marked by more selling" in the past, he warns. For the latest updates PRESS CTR + D or visit Stock Market news Today
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