What Could Happen to Major Stock Indices When a Correction Comes

NEW YORK (TheStreet) -- It has been a long time since the stock market had a correction. Today we're going to look at the potential lows the major averages could see when we do get one.

At the start of August the five major averages were in a technical formation that came close to signaling a correction.

On Friday, Aug. 8, the Dow Jones Industrial Average, S&P 500, Dow Jones Transportation Average and Russell 2000 had negative weekly charts with weekly closes below their five-week modified moving averages and with declining 12x3x3 weekly slow stochastics. The Nasdaq did not, however.

The Nasdaq closed that week one point above its five-week modified moving average with its weekly stochastic still overbought with a reading of more than 80.00. The following week, stocks began an impressive rebound and so did not confirm a correction.

I have always said that you cannot have a correction or bear market without all five major averages confirming market tops simultaneously. Without a fully negative configuration, new highs were very likely, and three of the five averages indeed went on to new highs.

The Dow industrials and S&P 500 set all-time intraday highs at 17,153.90 and 2005.04, respectively, on Aug. 26. After I wrote, "Apple, Intel, Microsoft, Netflix, Tesla Can Lead the Nasdaq Back Above 5000" on Aug. 28, the Nasdaq traded to a multiyear intraday high at 4580.27 on Aug. 29.

I would argue that the current situation is an equity bubble.

Today's first table illustrates the bubble risks:

The table shows the highs that were set between July 2007 and May 2008, before the 2008 crash, and the risks of what could happen when the current bubble bursts. Investors should print out this table as a reminder of these critical reflection levels.

The Russell 2000 was the first to peak, at 856.48 in July 2007. It declined 60% to its March 2009 low at 342.59. This index rallied 254% from this low to its all-time high at 1213.55 on July 1, 2014. The Russell 2000 is 42% above its prior high, which translates to downside risk of 29% to the prior high and 72% to the March 2009 low.

The Dow industrials peaked at 14,125 in October 2007 and declined 54% to the March 2009 low at 6470. This index rallied 165% from this low to its all-time high at 17,153.80 set on Aug. 26, 2014. The Dow Jones Industrial Average is 21% above its previous high, which translates to downside risk of 18% to the prior high and 62% to the March 2009 low.

The S&P 500 peaked at 1576.0 in October 2007 and declined 58% to its "devilish" March 2009 low at 666.8. This index rallied 201% from this low to its all-time high at 2005.04 set on Aug. 26, 2014. The S&P 500 is 27% above its prior high, which translates to downside risk of 21% to the prior high and 67% to the March 2009 low.

The Nasdaq peaked at 2861 in November 2007 and declined 56% to its March 2009 low at 1266. This index rallied 262% from this low to its all-time high at 4580.27 on Aug. 29, 2014. The Nasdaq is 60% above its prior high which translates to downside risk of 38% to the prior high and 72% to the March 2009 low.

The Dow Jones Transportation Average was the last to peak at 5537 in May 2008 and declined 62% to its March 2009 low at 2134. This index rallied 299% from this low to its all-time high at 8515.05 set on July 23, 2014. The transports are 54% above their prior high, which translates to downside risk of 35% to the prior high and 75% to the March 2009 low.

It is difficult to predict when these downside risks will be triggered, but the second table tracks the status of the weekly charts and provides the value levels and risky levels that can be used by investors to adjust market-related positions until we confirm the stock market peak.

The Dow Jones Industrial Average has a positive weekly chart with its five-week modified moving average at 16,854. This index is up only 3.1% year to date with monthly and semiannual value levels at 16,615 and 16,301, respectively, with quarterly and semiannual risky levels at 17,753 and 18,522, respectively. Annual value levels lag at 14,835 and 13,467.

The S&P 500 has a positive weekly chart with its five-week MMA at 1965.4. This index is up 8.4% year to date with monthly and semiannual value levels at 1978.2 and 1789.3, respectively, and with quarterly and semiannual risky levels at 2052.3 and 2080.3, respectively. Annual value levels lag at 1539.1 and 1442.1.

The Nasdaq has a positive but overbought weekly chart with its five-week MMA at 4451. This index is up 9.7% year to date with monthly and semiannual value levels at 4469 and 3972, respectively, with a quarterly pivot at 4569 and semianannual risky level at 4642. Annual value levels lag at 3471 and 3063.

The Dow Jones Transportation Index has a positive weekly chart with its five-week MMA at 8273. This index is up 14% year to date with quarterly and semiannual value levels at 8256 and 7423, respectively, with a monthly pivot at 8410 and semianannual risky level at 8447. Annual value levels lag at 6249 and 5935.

The Russell 2000 has a positive weekly chart with its five-MMA at 1153.95. This index is up just 0.9% year to date with monthly and semiannual value levels at 1149.70 and 1139.81, respectively, with semianannual and quarterly risky levels at 1285.37 and 1293.11, respectively. Annual value levels lag at 966.72 and 879.39.

At the time of publication the author held no positions in any of the stocks mentioned.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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