As the Bear Shows Its Teeth, Where Do Stocks Go Next?

stock traderWith the Dow Jones Industrial Average ($INDU) down over 250 points Wednesday, and all the major indexes off about 2%, it's worth thinking about where the market is headed. Is this the start of the market crash many have been anticipating, or just another jarring bump in the rally's bumpy ascent from the July lows? Let's start by reviewing the market's unsettling roller-coaster ride over the past few months.

Back on June 30, when the S&P 500 was in free-fall, I made the technical case for stocks to rise sharply, based on a classic stock pattern called "head and shoulders."

From there, stocks rose smartly, but then plummeted sharply on July 16 in a severe case of the jitters. On July 19 I suggested that the Bull rally was still kicking, and a break above a declining trendline would prove it. Soon thereafter, I proposed that the market might be following an A-B-C-D pattern, and a downleg amidst a continuing rally would be the next step in such a progression.

Technically, the market is now at an important inflection point. If the market doesn't stage a reversal soon, the Bearish view becomes increasingly strong. A case can be made that the S&P 500's rise to the 1,130 level formed a "right shoulder" and thus a waterfall decline is to be expected.

A Bearish Break

If we look at a daily chart of the S&P 500, we can see that Wednesday's drop has wreaked major technical damage.

  • After bouncing between the 200-day moving average (MA) and June's high for six days, the market has sliced through the 200-day line of support like a hot knife through butter. In May and June, this presaged a steep market decline.
  • The uptrend has been decisively broken
  • Moving average convergence-divergence (MACD) has rolled over into a Bearish cross, as has the stochastic.
  • Failure to break above the June high is negative.
  • The 20-day moving average support has also been broken.
  • The key psychological level of 1,100 has been broken.
Given all these negatives, this chart gives Bears plenty of reasons to rejoice. There is precious little technical evidence here for Bulls to hang their hope on.

Bear Battles Bull

The past four months have been characterized by numerous big down days. This increase in volatility suggests an epic battle between Bulls and Bears continues unabated. Some of the big days down have launched a free-fall, while others have been countered a few days later by equally significant recoveries.

The strongest evidence that the Bullish case has not been vanquished is sentiment. A fatalism that stocks are doomed is increasingly prevalent in the financial media. The Bull-Bear ratio is still low, meaning that there are plenty of Bears and relatively few Bulls.

The market rarely rewards the majority. Contrarians have found that a preponderance of Bears generally marks market bottoms, and a spike in the number of Bulls usually marks tops. Based on this historical evidence, a case can be made that this panicky decline is more likely a brick in the "wall of worry" than the start of a cascade to new lows. There is no sure thing in the market, of course, and perhaps the multitude of Bears are correct in their anticipation of a major decline.

For a longer-term perspective, let's turn to the weekly chart of the S&P 500 ($INX).

Perhaps the most striking feature of this chart is the flattening of the moving averages over the past few months as the Bulls and Bears have battled to a standstill between the 20-day and 50-day moving averages.

A Big Break -- but Which Way?

If we draw lines from the April highs and July lows to the present level around 1,092, we get a wedge or triangle. Technicians have noted that stocks tend to break up or down in a major way from triangles. In a way, they reflect the battle between two opposing trends, and one will eventually overcome the other.

On the positive side, the MACD on this chart is rising and is poised to climb above the neutral line. But if the SPX smashes down through its 50-day moving average at 1,088 without pause, the Bullish case has been dealt a major blow, and the Bear case will be greatly strengthened. If the SPX ignores the ceaseless torrent of bad economic news and rallies strongly off the 1,088 line in the sand, then the rally may yet stage a "Rocky"-like comeback.

The Bears have numerous powerful technical winds and a veritable flood of weak economic news at their backs. The Bulls have a much weaker case based on the high levels of negative sentiment.

As many have observed over the decades, the market has an uncanny knack for foiling the expectations of the majority, be they Bull or Bear. Now that the market is in yet another free-fall and the news flow is decidedly Bearish, a comeback rally would certainly qualify as unexpected. The Bulls best hope may be that the bad news has been discounted and the line in the sand at 1,088 will hold.

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Who wrote this? its wrong

September 01 2010 at 7:28 PM Report abuse rate up rate down Reply

DAily Finance is a daily bore to post comments cuz I cant read it after posted. What a real bore here!!!

August 12 2010 at 4:08 PM Report abuse rate up rate down Reply
Javier Cou

sell sell sell

August 12 2010 at 3:13 PM Report abuse +1 rate up rate down Reply

The blame it on Bush excusees are wearing out. BO criss crossed the country for 2 years running for president. Talking issues and forming his plans for the country. His policies are failing badley. The only good news in the last year is spun as its less bad. By next year people will be in a panic and want to be far from him. The question is is this being done on purpose or is it just incompatence.

August 12 2010 at 1:13 PM Report abuse +2 rate up rate down Reply

Aren't these theories like trying to count the number of likenesses of George Washington in a tree? Even if you get the number right, what have you proved? My rule is that whenever head and shoulders develop a case of dandruff, or if the waterfall send too many in barrels to their doom, try some fundamental analysis before investing.

August 12 2010 at 12:23 PM Report abuse -1 rate up rate down Reply


August 12 2010 at 12:20 PM Report abuse +4 rate up rate down Reply

Come o you guys on Wall Street can do better then that. You kill the market with all your what's in it for me (includeing Greenspan the main culprit!) You talk down the market for idiots like me to sell while your buying, then you talk up the market for idiots like me to buy while your selling. How many of you TOPPED NOTCHED players found yorself on the bread line? Those spots are for idiots like me!

August 12 2010 at 11:56 AM Report abuse +1 rate up rate down Reply

Blah blah blah,You can look at all the charts you want.The sad things is Americans are loosing confidence in America quickly.Look at Russia,South America.Jamaica ect. practically civil war.The thugs are running things and getting rich quick.The American corporations are not competing effectively and then turn around and ask for bailouts.American corporations spend tons of money on lobbyist and therefore politicians.You want to see another bull market?Install into the American people that there is justice in this land for rich and poor.We need immigration reform and educational reform.We neee to stop throwing our money down the toilet for this and that.We need to make our politicians accountable.

August 12 2010 at 11:27 AM Report abuse +4 rate up rate down Reply
2 replies to dtraindtrain's comment

We need to put an "s" on our plural words that end in "T". One lobbyist--two or more lobbyists. Ghosts, posts, dentists, guests, etc. Go thou and do likewise.

August 12 2010 at 1:03 PM Report abuse +1 rate up rate down Reply

Awwww does my grammar offend you?Typical,when someone doesn't like what is said they reduce themselves to grammar specialist instead of replying to the content of the message.Thank you teacher

August 12 2010 at 2:28 PM Report abuse +2 rate up rate down Reply

There is no jobs and proven by automation when it became reality!
There is no job when the high tech computers became reality.
There is no job when manufacturing went overseas!and reality!
There will never be the same hiring or jobs available when Capitalism has proven 100% Corrupt and run by the clones of Bernie Madoff and the Enron clones!!!
Japan did the same saying recovery in sight and never happened for over 25 years!
Same is going on in the US. The USPS is tied down by the UNIONS and when the no lay off clause dies,so will the jobs!!!!!!!
Come November you will see unemployment shoot higher!!!!!!!!
Remember this is and will remain the ERA of ENRONIZATION.

August 12 2010 at 10:26 AM Report abuse +2 rate up rate down Reply

As long as the Democrates stay in power we are all going to pay.NO JOBS SPENDING THE AMERICAN PEOPLES MONEY A HEALTH CARE BILL WILL PUT MOST OF US ON WELFARE.The 26b they past this week is nothing but bull.My daughter is a teacher and she makes good money,unions for Obama that is what this is.I pay taxes for the schools where is that money going.Stop spending the American peoples money.


August 12 2010 at 10:14 AM Report abuse +3 rate up rate down Reply