The stock market sell-off in the first few days of August was abnormally sharp, and appeared to trigger what IBD calls a "vertical violation" — a warning that indexes are not likely to bounce back anytime soon.
Historically, this signal leads to longer-term weakness, which means that investors should be in capital-preservation mode. You can expect at least a couple of months of choppy action and possibly a bear market.
The defining characteristic of the vertical violation is a sudden and sharp decline off the stock market's top. You might see several days of selling with just one feeble attempt to rebound. At least one of the days down will stick out: It's much larger than any of the days surrounding it. The big down day will often approach a drop of 3% or more.
On Monday, the Nasdaq fell 3.4% and the S&P 500 lost 3%.
Equal-Weight Stock Market Index Rolls Over
Typically, the three- or four-day sell-off begins with the indexes near their peaks, but that wasn't quite the case this time. The Nasdaq was nearly 6% below its July 11 peak before the three-day rout began.
However, the Invesco S&P 500 Equal Weight ETF, which is less influenced by the Magnificent Seven stocks, did sell off from its peak. Sector indexes such as Finance Select Sector SPDR and Industrial Select Sector SPDR showed similar action.
The S&P equal-weight ETF tentatively hit new highs on July 31. The following three sessions saw sharp losses in heavy volume, capped off with Monday's 2.4% decline. Also Monday, the ETF dived below its 50-day moving average, another key component of the vertical violation. It met resistance at the line Tuesday.
Monday's big decline resulted in another reduction in IBD's recommended market exposure. It is now at the 0%-20% range, reflecting a stock market in correction.
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What To Look For In Today's Stock Market
While the major stock indexes are bouncing back Tuesday, they still have plenty of work ahead of them to repair the damage.
The Nasdaq's bounce off the 200-day moving average Monday is crucial right now. Historically, once the indexes go below the 200-day, it's even more likely the stock market will be in a protracted correction.
If the market continues to rebound, it could deliver a follow-through bottoming signal. But keep in mind that the severity of the vertical violation is the stock market's way of saying it needs time to heal. Expect at least a couple of months before a market rally can take hold again. That means your first one or two follow-through days are more likely to fail after a vertical violation.
Truthfully, it's unknown how bad or how long the stock market weakness will get. But the historical precedent allows us to act decisively and defensively to protect capital.
Be sure to follow Scott Lehtonen on X, formerly known as Twitter, at @IBD_SLehtonen for more on growth stocks, the Dow Jones Industrial Average and the stock market today.
