As I noted in a DailyFinance column back in late December, various indicators such as interest rates and the Baltic Dry Index were flashing warning signs that the explosive rally the market had been experiencing since September was about to run into some headwinds. There's nothing fancy about the basic risk: Any rally that produces such dizzying gains in such a short span of time (see chart below) is vulnerable to a weakening of the euphoria that powered it.
One market truism -- not a law of nature, just an observation by technicians -- is that markets tend to exit a trend the way they entered it. If prices leaped up in a fast ascent, their fall tends to be just as steep. The same is true of sharp drops -- they are often followed by equally sharp recoveries.
We can see the near-vertical climb since September 2010 in the 10-year chart of the Nasdaq stock market.
Here's another observation that should give investors pause: The market has reversed at right around the same level as the 2007 peak. If the Nasdaq fails to rebound and climb decisively to a new high, this becomes a double-top -- a bearish technical signal that the current rally has topped out and reversed.
This theory on reversals is also valid at bottoms: When a market tests a recent low and holds as it did in late August 2010, forming a double-bottom, that's a good bullish signal.
Moving Average Predicts Serious Weakness
Technical analysis isn't a crystal ball: It provides us with models of what might happen, not predictions.
Looking at the one-year chart of the Nasdaq market, we see it's currently clinging precariously to a 50-day moving average of 2,720. Though two previous dips tested the 20-day moving average, this is the first instance since the rally began in September that price has broken below the 50-day MA. That suggests this period of weakness is more severe than previous outbreaks of nervousness.
That zone around 2,550 -- the level at which the market broke out to new highs -- is a major line in the sand. If the Nasdaq breaks down below that, it could be a harbinger of further declines. On the other hand, a sharp rebound back above 2,800 and a retest of previous highs would show the bull was only taking a brief breather.
The Dollar as an Inverse Indicator
As my DailyFinance colleague Joseph Lazzaro recently reported, the U.S. dollar has had some significantly bullish tradewinds filling its sails this year. As this 10-year chart of the DXY (dollar index) shows, this hasn't been positive for the U.S. stock market, as the dollar has been moving inversely to the stock market for most of the past decade.
While stocks steadily rose with only a few hiccups from late 2002 to mid-2008, the dollar declined by some 36%. Then, as panic struck the global financial markets in late 2008, the dollar rebounded strongly and stocks tanked.
While the inverse correlation isn't perfect, it's still significant: When stocks fell hard in May 2010, the dollar popped up. As stocks recovered, the dollar declined.
On this 10-year chart of the dollar, we see a distinctive uptrend since 2008, marked by higher lows. If the inverse correlation of the dollar and stocks holds -- and there is no guarantee it will -- then that slow, grinding rise in the dollar may be signaling a long-term headwind against further stock gains.
In a market that has showered strong gains on bulls, common sense -- and the technical indicators -- suggest that investors would be wise to set stop-loss orders now to protect profits and secure portfolios against further declines.