Is the Bull Down for the Count, or Just Taking a Break?

wall street bullThough solid corporate earnings drove the stock market up for seven straight sessions, the pummeling on Friday, July 16, took away the entire week's gain and left the market in a precarious position.

The news wasn't good on a number of fronts. Though corporate earnings were strong, revenues were weak, undermining the bullish story for the economy and the stock market. In an unwelcome stunner, consumer sentiment fell off a cliff, dropping to levels not seen since last March's lows.

In the last three decades, the consumer confidence index has dropped by such a large percentage only six times, and five of those followed major events such as the start of the 1990 Kuwait war or Sept. 11, 2001. That suggests consumers have suddenly lost faith in the nation's economic recovery. This is backed up by polls that show 78% of Americans think the nation is still in recession.

The bullish case for stocks has taken a number of hard knocks as well, as this chart illustrates:
S&P 500 chart for April through July
  • Seasonality. The stock market generally underperforms in the July-October time frame.
  • As many analysts have noted, the 50-day moving average has crossed through the 200-day moving average, a technical indicator that goes by the ominous name of "the Death Cross." This cross has often presaged bear markets -- but not always.
  • Connect the recent highs in the S&P 500 and the line points down, as the market notched lower highs and lower lows. Until the market can break above this trendline, it marks overhead resistance.
  • The S&P 500 has returned to the May 6 "Flash Crash" low at 1,064. Technically, this is a key inflection point, and breaking below that would suggest further weakness ahead.
  • Higher volume on down days. Volume tends to be lower in summer anyway, but high volume on down days isn't a sign of strength.
  • MACD (moving average convergence-divergence) is still below the neutral line and appears to be rolling over. The last time this indicator crossed, the market took a nasty fall.
  • The stochastic indicator is overbought and has turned down.
That's quite a load of negative indicators, and the bullish case for the market rests on fewer supports:
  • MACD is exhibiting some positive divergence, meaning that the indicator is rising even as price has fallen to new lows. This divergence often presages a turn in trend.
  • Negative sentiment is at an extreme, a condition found more often at market bottoms than at tops.
The Bears Are in the Majority

All the negative news and technical indicators such as The Death Cross aren't exactly secrets, and as a result contrarians look at the nearly universal negative view on the economy and stocks, and wonder if the market will do what it usually does, which is the opposite of what the majority of the players expect.

Put another way: The market rarely rewards an overwhelming consensus, and the majority is now definitely bearish -- stock bears outnumber bulls for the first time since April 2009, right after the market bottomed in March 2009.

This extreme of negative sentiment has the potential to reverse commonly accepted signals. For instance, in shallow downturns, the Death Cross becomes a buy signal, rather than a sure-fire signal to sell.

But being contrarian is no guarantee of being right, either. One recent analysis of the times when bears outnumber bulls found that in about a third of the cases, the market declined just as the bearish consensus expected.

The Next Line in the Sand

The key trait of technical analysis is that it's a series of "if-then" statements rather than a crystal ball. If the S&P 500 index doesn't find support around 1,060, a level of support going back to February's lows, then the next line in the sand is the June lows around 1,040 and 1,020. If the market falls to new lows, then another leg down in the decline from the April highs is underway.

If the market somehow musters enough buying to spark a rally that counters the numerous bearish factors, then it must break through the declining trendline to establish a new uptrend.

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