NEW YORK (TheStreet) -- If the S&P 500 pulls back 10%, look for it to continue sliding until it's off 15%-to-20%. If not, expect a new paradigm of smaller market moves (down 3% to 9%) that should be seen as buying opportunities.
The S&P 500 closed at 2,094.11 on Friday, about 1.7% off its recent high. It opened down another 0.8% today in early trading.^SPX data by YCharts
Every time we have the smallest of pullbacks in the stock market we immediately hear chatter about a market correction. For a majority of traders, when we hear the word correction, it is typically known as a pullback in the stock market of around 10%. Often, in bull markets we see 10% corrections as a good or healthy test for the market. It tests the will of the bulls and it brings in doubters that will short the market. This then gives the market volatility and more energy to either make a new high or potentially turn the market into a bear market with a 20% or more decline.
But the typical patterns of correction and rally have changed in the current market environment.
The current thinking on corrections doesn't take into account a world with quantitative easing, the Federal Reserve's bond-buying program that has pumped billions into the banking system. The Fed and European Central Bank QE programs have created a market that no one has ever seen before. In practice, QE means higher bond prices with lower lowered yields, while simultaneously increasing the monetary base. It forces traders to buy stocks as yields go lower and stocks go higher. QE has created crowded, one-dimensional markets that almost don't allow 10% corrections, but it does allow a lot of minor corrections; typically 3%-to-9% pullbacks. These are not the corrections that veteran traders are used to and are anticipating as buying opportunities, but that is the new environment for the market.
For those traders still clinging to old-school methodologies waiting for the eventual 10% correction, my advice is stop waiting for it. If it does happen, I think that it will be a sell signal, not a buying opportunity. The market never gives us exactly what we want, and when it does, it's almost always wrong (at least initially). A recent example would be the Dax. The Dax consists of the 30 major German companies making it the most important market to watch in Europe because Germany is the largest economy in the region. Over the past couple of months the Dax has fallen off by 1,568 points, over 12% from recent highs. No one knows whether or not this is a correction or if the top is in because of the uncertainty coming from the ECB and its QE program. This same scenario could play out in the U.S. stock market, in particular the S&P 500.
Because of QE, the ECB and Federal Reserve have changed the natural flow of markets. Forcing investors into certain buying behaviors can work for a while, but when the trend reverses, it's a race to get out -- and no one wants to be the last one out.
When the S&P goes down 10%, and it will happen, we will be faced with this same question that Dax investors are faced with right now and that uncertainty will take us lower than 10%. If the S&P goes down 10%, it will actually be a sell signal and turn into a 15%-to-20% correction, taking us right to the cusp of a bear market. If the S&P is going to continue higher, then expect more 3%-to-9% corrections.
A key level to watch going forward in the E-mini S&P futures is the March low of 2,030.75. March typically makes an important low or high for the year and in the past if that low or high gets violated after the second quarter we usually see a sharp move in that direction. If 2,030.75 gets violated, it creates a very high probability that we will see new lows for the year in the S&P.