StockCharts Blogs - ChartWatchers

STOCKS STILL OVERVALUED

Stocks have been in the overvalued end of the normal P/E range since the early-1990s, and this condition shows no sign of abating. Below is an excerpt from our daily earnings summary that will offer readers a better perspective. I have outlined the 2009 Q4 results because that is the first quarter not distorted by the huge loss reported in 2008 Q4. While the results of the current quarter are not final, 90% of companies have reported, and I don't think there will be any surprises from the remaining companies sufficient to change the estimated results a substantial amount. As you can see, valuations are projected to be well above the overvalued limit of the range (P/E of 20) through the first two quarters of 2010. If the market continues to rally, the over valuation will persist into the foreseeable future.

Since price movement over the last two decades seems to have little relationship to P/E ratios, why pay any attention to values? In fact, Decision Point's trend-following models consider price movement and nothing else. Nevertheless, we still want to be aware of the condition of the fundamental foundation of the market, and we believe that investor ignorance in this regard will only lead to more pain. After all, investors have been ignoring valuations for nearly two decades, and the result has been a stock bubble and two major bear markets. Most have not fared well during this period.

At each price top for the last two months I have been expecting a correction to begin, yet price declines have been relatively small and each top is followed by a higher top. Frustrating! I am not trying to identify a shorting opportunity, because shorting is not recommended during a bull market. The only reason that a decent correction is important is that it will provide a lower-risk opportunity to open new long positions.

For two weeks the market has been rolling over into what could be another short-term top. Or it could be the beginning of the long-awaited correction. Negative divergences still abound, but, as I told a subscriber, these conditions are usually not too serious in a bull market. The market is vulnerable, but it is not a time for shorting. We could reasonably expect the rising wedge pattern to break down, but you can see that there is support just below the wedge.

Bottom Line: Market P/E tells us that there is no fundamental foundation under the market. This information is not useful in timing decisions, but it does tell us that there is more pain ahead in the long-term. In the short-term the market is topping again, and a correction is still possible.

MARKET IS STRONG, BUT CORRECTION SHOULD CONTINUE

Looking at the S&P 500 chart below, the breakdown from the ascending wedge pattern is clear enough, and expectation of the breakdown has been fulfilled. The rising trend line violation brings with it the expectation of a continued decline, but I do not have a price target at this time. The horizontal dotted lines show the closest and furthest likely support levels, but I have no expectations regarding either one.

At this point, I am still expecting a price low at the end of this month based on the 20-Week Cycle low projection, but it doesn't look as if the price correction will be too severe. My reasoning is that so far short-term oversold conditions are generating very strong bounces. Of course, this could change in a heart beat, so keep an eye on it.

Technically speaking, we do not yet have a down trend -- we need a lower high and a lower low.

When we think of a correction, we usually imagine a fairly straight forward decline, but there are other possibilities, such as a consolidation phase. When I looked at the longer-term chart below, it struck me how similar the current rally is to the rally off the 2003 low. There was a sharp leg up, followed by a short consolidation, followed by another leg up. At that point, many people expected a corrective decline. Instead, there was a sideways consolidation with a modest downward bias. I do not assert that the same kind of pattern will evolve this time. I just wanted to illustrate the possibility of other outcomes.

Gold hit an all-time high this week, and it is rising in the face of rising currencies. Gold typically falls when currencies are rising, so many analysts are suggesting that people are starting to view gold as the new reserve currency. On the chart below you can see that gold is being contained by a rising trend channel, so the next move should be back to the bottom of that channel; however, if people are moving away from paper currency, there is the possibility for gold to go ballistic.

Bottom Line: Based solely upon the rising trend line violation, I am assuming that the market is in a corrective phase that will last for several weeks; however, a declining trend has not yet been established, and my assumption could be premature.

OIL ETF BACK ON BUY SIGNAL

In my September 25 article I headlined the fact that the Oil ETF (USO) had generated convincing sell signal, so I think it is appropriate to report that the signal has recently turned to a buy. Below is the chart from the 9/25 article showing the breakdown from the triangle formation that accompanied the sell signal. It still looks good to me, but that breakdown turned out to be a shakeout, a final decline clearing the market of sellers and setting up another advance.

On the next chart you can see how the shakeout lows redefined the lower limits and shape of the triangle. Prices rallied off the shakeout base and broke through the top of the triangle. Prices have also broken through the 200-EMA, so I think this move has a lot of credibility. Of course, I also thought the sell signal was very credible too, but we must change our opinion as the evidence demands.

Gold has also made a decisive break above important overhead resistance. I have been concerned that gold would not be able to do this because a rally in the dollar seemed imminent, but the dollar has failed to rally, and gold has shown its strength. At this point I wonder if the oversold condition of the dollar will lead it to decline even further. The technical expectation for gold at this point is for a pullback toward the recently penetrated resistance, now support.

Stock prices have continued to move higher in spite of broad expectations for a decent correction. Looking at the weekly chart of the S&P 500, we get a longer-term perspective. The price index is headed into an apex where the long-term declining tops line and the top of the ascending wedge pattern converge. It sure looks like a rally stopper to me. The crystal ball says rally top should be in place within a week or two.

Bottom Line: Breakouts in the prices of oil and gold indicate a lack of confidence in the ability of the dollar to rally. Stock prices are approaching long-term resistance, and there is a strong possibility that the rally will finally end. That is not to say that the bull market will be over at that point, but a healthy correction is overdue.

SUPPORT STILL HOLDS CORRECTING PRICES

The market has begun another correction, but so far no serious technical damage has been done. The S&P 500 remains within the grasp of an ascending wedge formation, the dominant feature on the daily chart. On Friday prices hit their lowest level of the correction, but they remained above the support of the 50-EMA and the rising trend line. Next major support is at the 200-EMA.

As regular readers know, it is most likely that prices will break down from the rising wedge pattern, and I am inclined to believe that will happen in this case. Internal conditions for the medium-term are neutral to slightly overbought, and I think the market needs to get medium-term oversold before the correction will end. Also, it is October, and a certain amount of ugliness should be expected. I hear that a number of people are expecting a crash, but I see no evidence that would make me anticipate anything more than a normal correction.

The following Participation Index (PI) chart shows that the short-term market condition is oversold. This could signal a short-term bounce, or the end of the correction. The latter is unlikely because the market needs to get more oversold medium-term before another up leg begins.

Bottom Line: It is very likely that the S&P 500 will break down out of the rising wedge pattern soon. With luck a breakdown will be followed by a healthy correction, but we are in a bull market and I wouldn't bet on anything worse than that.  

BULL MARKET RULES STILL APPLY

For weeks we have been looking for a correction, and a time or two we experienced some trepidation that the bull market might be over, but all the market has done is produce a series of minor pullbacks. At the present it is trying to break out of a rising wedge formation, the opposite of what we normally expect with a bearish formation. This kind of behavior continues to supply us with evidence that bull market rules still apply. That means that we should continue to expect bullish resolutions rather than bearish ones.

Market internals have continued to remain overbought. For example, the PMO (Price Momentum Oscillator) on the above chart is near the top of its normal range. On the chart below we see three indicators representing the ultra-short-, short- and medium-term time frames. You can see how they have all reached overbought levels and topped. In a neutral or negative market, this would present a great sell signal, but you can also see how twice before these conditions failed to produce any serious decline. Perhaps the third time is charmed?

Bottom Line: Many market indicators are overbought and topping, presenting us with yet another setup for a correction, but bull market rules say we shouldn't count on it. A small pullback is more likely. To be sure, our bullish assumptions will ultimately prove wrong when the final top of this rally arrives, but our trend following models keep us from pulling the trigger prematurely. We remain on a 3/17/2009 medium-term buy signal for the S&P 500.

LOOKING BACK

I continue to get mail from people who question how it is possible to be bullish in the face of the worst fundamentals since the Great Depression, so I thought it would be useful to look at a chart of the 1929 Crash and the decade that followed it.

Squeezed on the left side of the chart you can see the initial Crash and the rally that followed it into mid-1930. That was a bear market rally, and it advanced about 50% from the Crash low. While all our current signals are bullish, I still have no problem imagining our current rally ultimately resolving in this manner. The point, however, is that the big rally in 1930 occurred at a time that the fundamental problems had hardly been acknowledged, let alone solved.

After the final low in 1932 the market rallied for over four years and 300% during what has to be characterized as the depths of the Depression. I do not mean to assert that this is what I expect from our current situation, only to demonstrate what can happen and how fundamentals can often be at odds with price movement.

 

Moving back to the present, let's take a look at a weekly-based chart of the S&P 500. As of Friday's close, the 17-EMA crossed up through the 43-EMA by a thin, thin, thin margin of 0.03. This is the approximate equivalent of a 50/200-EMA crossover on the daily-based chart, and it confirms the long-term (months to years) buy signal we got on August 11.

What bothers me on this chart is the ascending wedge pattern, which looks more ominous from a weekly perspective than it does from a daily view. It is hard for me to imagine this wedge resolving any way but downward. I cannot picture in my mind a congruous price pattern that could result from an upside breakout. Once a correction is completed, more sensible possibilities could emerge. I guess this opinion falls under the heading of "gut feeling", but it comes from a person who has looked at a lot of charts for a lot of years.

Bottom Line: Medium-term indicators are still quite overbought, and a correction would be the best way to clear this condition. Is entirely possible that we have seen the top of the rally/bull market, but medium- and long-term signals are positive, so I think the worst case we should expect for now is a correction. Our medium-term timing model will switch to neutral from buy if the S&P 500 daily 20-EMA crosses down through the 50-EMA. 

HOPING FOR A PULLBACK

Since the price lows of early-July, the market has moved relentlessly higher, penetrating the important resistance posed by the 200-EMA. When this rally began, a narrow window of fairly low-risk opportunity was presented. Those who missed it are now hoping that prices will pull back far enough to provide another good entry point.

The most obvious and promising pullback target would be a move down to the 200-EMA, but would such a move fuel confidence, or would it only serve to crank up the level of anxiety? As you can see, another ascending wedge has formed, and, if you have been following our commentary for a while, you know that an ascending wedge is a bearish formation with a high probability of a breakdown. If we do get a pullback, the next obvious fear will be that the pullback will not end, and that prices will break down from the wedge and continue on down to test the July lows.

 

Adding to the evidence supporting a possible breakdown are medium-term indicators, like those below, showing that the market is quite overbought, a condition that will need to be cleared. In bull market conditions, which I would ascribe to our current situation, it is possible for overbought conditions to be worked off even as prices move higher. That is to say that prices may not pull back at all, but simply break up and out of the wedge. To the other extreme, a healthy price decline can do the trick.

Bottom Line: For those who acted on our March 17 buy signal, contemplating the outcome of the ascending wedge and/or the possible pullback does not create much, if any, stress. But for those who are still out of the market and looking for a chance to participate in another up leg that has the potential to move prices up another 20%, the next few weeks will probably not be much fun.

One of these days, the market mood is going to switch back to bearish for an extended period, but, based upon price action to date, I must assume that the current setup will resolve in favor of the bulls, meaning that I don't think the wedge will be broken to the downside.

BREAKDOWN BECOMES BEAR TRAP

Last week I presented an alternate scenario to the head and shoulders breakdown and projected decline:

"While the bearish case seems strongest at this point, a bullish outcome is not impossible. Bullish forces have weakened, but it is not at all clear that the bear market has resumed. A more positive analysis of the situation could be that there has been a two-month rally from the March lows, followed by a two-month correction/consolidation. The neckline violation could be the end of the correction and a bear trap. I present this outcome because I have seen it happen before, and it is not yet out of reach; however, I don't think it is likely."

Well, I didn't think it was likely, but that is what happened. I don't feel too bad about that because our Thrust/Trend Model is still on a medium-term buy signal, proving once again that the timing model is smarter than I am. But being wrong can also impart useful information. Since the bearish formation ultimately resolved in a bullish direction, we can assume that bullish forces are in command, and that the rally will continue.

So now, with the head and shoulders pattern having evaporated, we need to attempt to apply another context to the price pattern. The most obvious at this point is that the decline from the June top was a correction/consolidation for the advance off the March lows. I have drawn lines to define the top and bottom of the declining trend channel, which looks a lot like a flag formation hung on a lazy flag pole. There has been a strong breakout above the top of the channel.

 

The concern at this point, "Is the breakout really just a blowoff?" The June top has not yet been exceeded, volume on the breakout was unimpressive, and short-term indicators are very overbought. Below is a chart of the CVI (Climactic Volume Indicator) and STVO (Short-Term Volume Oscillator). Both have reached climactic levels, but as usual we are left to decide if it is an initiation climax or an exhaustion climax (blowoff). My opinion is that it is an initiation climax, because it has occurred after a price consolidation, rather than at the top of an advance. Also, most medium-term indicators are not overbought.

Using flag pole as a measuring stick, I estimate a possible upside price target of 1200. Assuming that price is in the ball park, our long-term model, which is still bearish, will be switching to bullish very soon. Until then, I will still assume that the long-term is bearish, but I thought it worthwhile to point out that we are nearing a tipping point.

Bottom Line: The violation of the head and shoulders neckline has proven to be a bear trap, and my opinion is that the rally from the March lows is resuming. My upside price target is about 1200 on the S&P 500. I have to say that this doesn't make any sense considering what I think I know about the economy, which is why I try to ignore fundamentals in favor of the charts.

GOLDEN CROSS

About a week ago the S&P 500 50-SMA (simple moving average) crossed up through the 200-SMA. (See chart below.) This is known as a "Golden Cross" because it is interpreted by many as a sign that the market is turning long-term bullish. Of course, this generated enormous optimism among the market cheerleader crowd, most of whom do not use technical analysis unless it supports their position. On the other hand, a highly regarded economist/market analyst blew his stack that anyone could be so lame-brained to use such a simple event to imply that the market was about to go ballistic. Since both sides of this argument regarding a technical event are offered by people who are fundamental analysts, I thought it would be useful to present a technician's point of view.

First of all, a 50/200-SMA crossover means nothing to this technician because I use exponential moving averages, and a golden cross has not yet occurred on the 50/200-EMAs. (See my article of June 19.) Second, if we were to get a 50/200-EMA golden cross, it would be an important event, but it would not be a sign to pile back into the market with both feet.

A golden cross applies only to the price index where it occurs. With the S&P 500 it means, based upon price movement, the broad market is turning positive, and, in technical terms, we will have entered a long-term bull market. At that point we would shift our emphasis away from shorts and toward longs. We would start assessing indicators and setups based on the assumption that we were in a bull market.

Sure, false signals are generated, but we can only act on what we know. In this case we would begin to look for medium- and short-term setups for long positions. If the LT buy signal fails, chances are that good setups will not be very common, and good position management will limit losses. A golden cross is not useless, nor is it a signal to throw caution to the wind. It is really an information signal, not an action signal.

The next chart shows the current market conditions using EMAs. Note that we are still awaiting the golden cross. More immediate to our attention is the fact that a fully developed head and shoulders pattern has formed, and Thursday's decline appears to be setting up challenge to the neckline. If the pattern executes (the price index violates the neckline), the minimum downside target is about 810.

If the pattern fails to execute and prices rally off the neckline, it will tell us that medium-term bullish forces are still in effect.

 

Bottom Line: The golden cross is a positive sign and gives us information about the market's condition and trend. If it occurs, don't overreact or ignore it. There is currently a head and shoulders pattern that is on the verge of violating its neckline. If that happens, it would be a pretty good sign that the rally is over.

BREAKDOWN AND SNAPBACK

On Monday, in predictable fashion, prices broke down from the ascending wedge pattern we've been watching. Then, after a correction of 5%, prices began a snapback move up toward the recently violated support line (now overhead resistance). Prior to the breakdown, you will notice that overhead resistance was presented by the 200-EMA (exponential moving average), which also happens to coincide with the top of the wedge pattern. Once the snapback is completed, I am inclined to expect the correction to continue for a while. There is good support at 880, and after that the most obvious support is around 670.

As I mentioned last week, medium-term negative divergences are beginning to appear -- the PMO and fading volume on the chart below are two examples. Also, we are in the six-month period of negative seasonality, which will last through October. The mini-bull market has had quite a nice run, but, since we are still in a secular bear market, we should consider that perhaps prices are starting to roll over in order for the bear market to resume.

To change the subject, now seems like a good time to address the differences between the simple moving average (SMA) and the exponential moving average (EMA). A 200-SMA is the average of the last 200 days closing prices. To calculate today's 200-SMA, you drop the first price in the series (200 days ago), add today's closing price, then divide by 200. As you can see, the price 200 days ago has the same weight as today's close.

The EMA is weighted almost totally toward recent activity. To calculate a 200-EMA you begin with yesterday's EMA, subtract 1/200th of that number, and add 1/200th of today's closing price. (Math wonks will probably take issue, but it's close enough to help grasp the concept.) With the EMA we will not have a large move that happened 200 days ago affecting today's EMA.

The reason I am discussing this issue is to demonstrate how EMAs and SMAs can present completely different pictures. On the chart above, which uses EMAs, you can see how the 200-EMA appears to have stopped the forward progress of the S&P 500. There is also a substantial gap between the 50-EMA and the 200-EMA. (A 50/200-EMA upside crossover would generate a long-term buy signal.) On the chart below, which uses SMAs, the S&P 500 has broken above the 200-SMA, and the 50-SMA is about to break up through the 200-EMA (long-term buy signal).

Obviously, the SMAs present a positive picture versus an ongoing negative picture presented by EMAs, and such divergences are fairly common. So which one are you going to believe? I don't know how this will ultimately resolve, but I believe and will act upon the EMAs. I have always preferred EMAs because they do not give much weight to old numbers, but others prefer SMAs. In any case, you should use one or the other and stick with it.

 

Bottom Line: The ascending wedge formation resolved downward, and after a small decline, a reaction rally (snapback) has taken place. While downside resolution of this formation has only short-term implications, it is my opinion that medium-term correction has begun.

IMPORTANT RESISTANCE ENCOUNTERED

On the chart below we could attach a callout window to the rally that began in March and entitle it "Bull Market Rules Apply". Bull market rules generally mean that bullish setups will almost always resolve positively, and that bearish setups will usually fail to execute, because the market is being driven by a strong bullish bias. For example, at the early-May price top we had a perfect setup for a price reversal that could have declined into a nice correction. Many medium-term indicators were very overbought, and that condition needed to be cleared.

However, instead of correcting downward, prices moved sideways in a consolidation pattern, clearing the overbought condition without giving up any significant ground. Then at the end of the consolidation a strong breakout occurred. This breakout could have been a blowoff top, but, instead of immediately reversing downward, prices began to consolidate (so far for four days), erasing any hope the bears may have had for a decline.

Now, as you can see, prices have hit resistance at the 200-EMA. Not only that, but there is a long-term declining tops line just ahead. This resistance is strong and significant, and a reasonable assumption is that prices will be turned back from it.

On the weekly-based S&P 500 chart below, the declining tops line is displayed in its entirety, and its significance is more easily grasped.

So what's next? If the underlying bullish market bias persists, then the resistance will be overcome; however, the rally has gone long and far enough that it could be time for it to end. I think it is too late to open new longs, and too early to go short. We have been on a buy signal since March 17 and are sitting on a nice gain, so we can comfortably sit tight and wait to see what happens.

Bottom Line: We have experienced a nice rally from the March lows, but the price index has encountered important, and presumably strong, resistance. The chart evidence make a compelling argument that the rally is finally over, but the market's positive behavior to date warns against getting too bearish too soon.

REVERSE HEAD AND SHOULDERS FORMING?

The ascending wedge pattern we discussed last week has broken down as we expected. Considering that the market has rallied nearly 40%, I think it is reasonable to expect more corrective action.

The next development to watch is the possible formation of a reverse head and shoulders. We currently have the left shoulder, head, and neckline. The correction that has started could result in a right shoulder, if the correction does not turn into the next leg of the bear market. The ideal resolution (if you are a bull) would be for the correction to end in the area of 750-800, then for a rally to blast up through the neckline. If that were to happen, the minimum upside target would be equal to the distance between the top of the head and the neckline -- about 1200. Interesting to contemplate, but, hey, we are way ahead of ourselves at this point.

As you can see on the chart below, intermediate-term indicators are still very overbought. This evidence supports the idea that the correction is not over yet.

Bottom Line: The short-term indicators, although oversold, have shifted from a persistently positive range to a more normal range. I interpret this to mean that the invincible nature of the rising trend has come to an end. Coupled with the fact that medium-term indicators are still quite overbought, my conclusion is that there are probably a few more weeks of correction ahead of us. The appearance of some elements of a reverse head and shoulders offer some hope that a major bottom could be forming, but it is too early to turn up the optimism in that regard.

STEADY ADVANCE PERSISTS

I have been referring to the slow, steady advance of the last few weeks as a "correction". To be more specific, it is a "running correction", which means that prices have moved higher as indicators have chopped sideways and lower. This is evident on the chart below which shows the CVI and STVO (two short-term volume indicators). The CVI has been oscillating above the zero line in an ever-narrowing range for almost two months. The STVO is almost become a flat line. This kind of indicator activity is very unusual, and the impression I get when I look at the charts is that it is not likely to last much longer.

Looking at the medium-term breadth and volume indicators below, I am concerned that the overbought conditions are so extreme and the indicators have just barely topped. This condition must be cleared, but it doesn't necessarily need to be cleared by a big price decline. Looking to the left side of the chart, you can see two instances where overbought conditions were cleared as the market moved higher. I believe we will see a similar resolution this time.

Bottom Line: We are in a long-term bear market, but we also have a medium-term buy signal, which means that bull market rules apply at the present time. Market action has been persistently positive since the March price low, and overbought conditions are most likely to clear in a non-destructive way.

PULLBACK IS LIKELY, BUT NOT GUARANTEED

The bear market rally has continued to move prices higher, and the strength is greatest in the smaller-cap stocks. For example, the S&P 500 has rallied 30% from the March lows, but the Rydex S&P Equal Weight ETF (RSP) has advanced 45%. Looking through the list of the Spider Sectors and their equal weighted counterparts, we can see that the equal weighted indexes are doing much better than the traditional cap-weighted indexes. Nevertheless, the S&P 500 has managed to move above the medium-term resistance presented by the declining tops line of the recent trading channel.

As we have noted in recent articles, prices have been advancing in the face of overbought short-term indicators. See the CVI below. It has stayed mostly on the overbought side of the zero line, and prices have moved higher as th CVI has diverged negatively. This is bullish and is evidence that the rally is probably not over; however, medium-term indicators are now becoming overbought. Note that the S&P 500 PMO (above) is above 2.5, and the VTO below are very overbought.

On the chart below we can see that our intermediate-term breadth and volume indicators are very overbought by historical standards. In a bear market this can be a problem; however, a bear market rally is like a mini-bull market, so it is possible for overbought conditions to clear without much (or even any) price deterioration.

Bottom Line: Based upon my perception of market behavior versus indicator status, I am expecting some kind of correction, possibly a short consolidation -- a week or so -- or a quick, scary couple of down days. Regardless of how the overbought conditions are cleared, I am assuming that the rally is not over and will persist for at least a few more weeks.

RALLY CONTINUES

Last Friday I said we should be looking for a short-correction because the CVI (Climactic Volume Oscillator) was very overbought, and prices were approaching overhead resistance. There was a very small correction, but prices kept moving higher, while the CVI zigzagged at overbought levels. We also observed the STVO (Short-Term Volume Oscillator) move down from overbought to neutral. This is the kind of thing that happens in bull markets, and bear market rallys. There is no guarantee that this bullish behavior will continue, but I suspect that it will.

Now medium-term indicators are reaching overbought levels -- see the VTO above and the intermediate-term breadth and volume indicators below. Clearing this overbought condition will be more difficult than the short-term clearing was.

Further complicating the issue is the overhead resistance. The market has reached the resistance line at the same time that internals have become overbought. A breakout at this time would be a very bullish sign; however, a real pullback, allowing the buildup of some internal compression would not necessarily be a bad thing.

Bottom Line: The market has been behaving in a positive manner ever since it rallied off the March lows. Of course it is possible that the bullish phase will suddenly fade, but for now I think we are experiencing a bear market rally that could move the S&P 500 up to the area of 1000.

SHORT-TERM TOP

Quite a few years ago I used to write a daily newsletter, but I decided to give it up because it got tiresome trying to invent new ways to say the same thing over and over. More important, having to form an opinion on the market every single day, especially during volatile times as we have been experiencing, can build a of stress. Also, since I am primarily focused on the intermediate-term and long-term time frames, it can be counter productive to put too much effort into short-term analysis.

This week was especially challenging due to the Fed's announcement, which caused big rallies in stocks, bonds, and commodities, and a big decline in the dollar. Also, a number of market and sector indexes switched to buy signals. (Standby for more whipsaw.) The question remains as to whether the Fed's announcement will have a lasting effect, or if it will prove to be another flash in the pan.

On our first chart we can see that prices moved slightly above important resistance levels, but they have not made a clear breakout.

The next issue is that the market is short-term overbought. The Climactic Volume Indicator (CVI) is extremely overbought, as is the Short-Term Volume Oscillator (STVO), which hit its second highest level ever (the highest was in January). Since we are still in a bear market, chances are very high that the market has hit a short-term top, and that a short-term correction is under way.

 

On an intermediate-term basis, internal conditions are neutral, as shown by our intermediate-term breadth and volume indicators. This allows for a short correction and the resumption of the up trend; however, bear market conditions demand that we consider that a more negative outcome is possible.

 

Bottom Line: The surge in prices this week has given bulls some encouragement, but my overall expectations remain bearish.

BREAKDOWN!

At the end of last week the S&P 500 had declined to and had settled on the support created by the November lows. It was poised to either rally and lock in a double bottom, or break down. On Monday prices broke down through support, and by Thursday's close it could be said that the breakdown was "decisive". When a breakdown is classified as decisive (greater than 3%), it means that chances are very high that the market will not be able to gather enough strength to rally back above the recently violated support. Reaction rallies back toward the support are possible, but not guaranteed.

The monthly-based chart below provides a better perspective of the seriousness of the breakdown, and we can also see the location of future support levels. The next support is at 600, at the low of the medium-term correction in 1996. I do not consider this an important support level. The first important support I see is the line drawn across the 1994 consolidation lows -- around 450 on the S&P 500.


The market is now very oversold in the medium-term and long-term, but in a secular bear market this is not a cause for rejoicing. Bear markets can crash out of oversold conditions.

Bottom Line: The S&P 500 has decisively violated important support, and the most likely consequence is that prices will continue to decline, with 600 on the S&P being the most obvious level for us to see a bounce of any significance. While we could see a bounce before then, I think we should be more concerned that the decline will accelerate into a crash. There are still investors who have endured the decline from the bull market top and who were hoping that the 2002 bear market lows would mark the end of the current bear market. Now that long-term support has been clearly broken, another round of panic selling could be just around the corner.

RETEST

The long-awaited retest of the November lows has finally arrived. The S&P 500 is still slightly above that support, but the Dow has penetrated it. Even though every rally since November has been greeted with intense hope of a new advance that would end the bear market, the market gradually rolled over into a declining trend after the January top.

The November bottom was also a 9-Month Cycle bottom. In a bull market we would expect the market to rally for several months. The fact that the rally failed so quickly, is a very bearish sign.

 

The longer-term view shows that the 2002 bear market lows are also being tested again, so the market is at a very critical point. Many people who are still holding equities (at a 50% loss) are counting on being bailed out by a big rally. If prices fall significantly below long-term support, we are likely to see another selling stampede.

The long-term condition of the market is deeply oversold, as demonstrated by the Percent of Stocks Above Their 200-EMA. This indicator has never been at these low levels for such an extended period of time. Normally, a rally is in the cards as soon as these levels are reached, but the market is flat on its back, and it is hard to say when it will recover. It is important not to get too anxious to get back in. We are in a bear market, and negative outcomes are much more likely than positive ones.

Also, remember that oversold conditions in a bear market are extremely dangerous. If the current support zone fails, a market crash could quickly follow.

 

The medium-term condition of the market is neutral. Note that the ITBM and ITVM charts below are mid-range and falling. This is not a level from which we would expect a powerful rally to be launched.

 

Bottom Line: The market is in the midst of a retest of very important support. Since we are in a bear market, I expect that the support will fail.

Technical analysis is a windsock, not a crystal ball. Be prepared to adjust your tactics and strategy if conditions change.

JANUARY FORECASTS A DOWN YEAR

Research published by Yale Hirsch in the "Trader's Almanac" shows that market performance during the month of January often predicts market performance for the entire year. The January "barometer" has been particularly prescient in odd years (the first year of a new Congress), with only two misses in 69 years (as of 12/31/2008). While the January barometer has a good record of prediction, I still put it in the "for what its worth" column, because I can't think of any sound reason why it should work, and in many years it seems that a correct forecast is simply serendipity.

As usual we think you should view charts of actual market movement before making decisions based on reported average performance. For example, in 1987 the January Barometer forecast an up year. Well, it was an up year, but what a wild ride! On our website we have an extensive series of these charts going back to 1920. It is worth studying the charts so that you have an educated opinion of how this forecast device really works.

Bottom Line: The January barometer predicts that 2009 will be a down year. Regardless of what the barometer says, I think it is wishful thinking to believe that 2009 will be a winner. Consumers, which are 70% of our economy, are scared to death for their jobs. Until unemployment stops rising I think investor risk aversion will remain high.

RALLY FAILURE

In my January 2 article I pointed out that the stock market was overbought by bear market standards, but that the rally had plenty of internal room for prices to expand upward if bullish forces were to persist. There was a brief rally and a small breakout, but then the rally failed, breaking down from an ascending wedge formation. I wasn't really expecting a bullish resolution, but one must keep an open mind when appropriate conditions appear.

On the chart below you can see the short-term declining tops line through which the breakout occurred. Instead of a buying opportunity, it was a bull trap. At this point we must assume that the November low will be tested. Note also that the PMO has crossed down through its 10-EMA, generating a sell signal.

The weekly chart below gives a better perspective, I think. It shows how aggressive the current down move is compared to the price activity that precedes it. Also, the PMO has topped below its moving average, a bearish sign. Prices are once again approaching the long-term support drawn from the 2002 lows. A successful retest could set up a double bottom from which another intermediate-term rally could launch, but in a bear market we shouldn't bet on that outcome.

For many months I have been emphasizing that our analysis should be biased toward bearish outcomes because we are operating in the longer-term context of a bear market. The tide is going out and it is foolish to try to swim against it. In a much broader context, we are in the midst of a global debt collapse that is only in the beginning stages. I find it impossible to imagine economic circumstances in the immediate future that would be even remotely favorable to stocks.

Bottom Line: In a bull market overbought conditions most often result in small corrections, consolidations, or deceleration of the up trend. In a bear market overbought conditions are usually a sign that a price top is at hand. Because the most recent overbought event has resulted in a price top, I think we can safely assume that the bear has not retreated.

HOW OVERBOUGHT IS IT?

For the last few weeks the stock market has been drifting higher on low volume, and there is no doubt in my mind that the Fed/Treasury has been the invisible hand that has quickly moved in to squelch any selling that started. Under these conditions, I find it difficult to draw any solid conclusions from indicators that have been fed a diet of questionable market activity. Nevertheless, we must work with the information we have and accept it at face value until more normal market action increases our confidence in our conclusions.

Looking at the chart below we can see pretty much all there is to see in the medium-term picture. Breadth and volume indicators are clearly in the overbought side of the trading range. Based upon the range we have seen during the bear market, internals are very overbought, but, relative to the normal indicator ranges, the indicators have a long way to go up if the rally continues.

The PMO (Price Momentum Oscillator) is still below the zero line, but it is recovering from the lowest reading since the 1987 Crash, and, relatively speaking, it too is overbought. However, there is still plenty of room before a continued rally will move the PMO to normal overbought levels.

Looking at the price index, we can see the S&P 500 is coming out of a "V" bottom, and there is plenty of room for it to rally before it hits serious overhead resistance. A rally up to that resisitance would convince most people that the bear market was over, but it wouldn't be. And by then the market would be seriously overbought by any standard.

In the short-term the market is very overbought, as demonstrated by the CVI (Climactic Volume Indicator) chart below; however, CVI readings this high can also be an initial impulse that initiates a rally.

Bottom Line: By bear market standards the market is overbought and due for a correction, but there is plenty of room for prices and indicators to expand upward. The low volume associated with the rally dampens my enthusiasm for the positive signs that exist, and I wonder if investors are ready to forget the fear that has been generated by the severe beating they have been dealt by the economy and falling markets.

TIME RUNNING OUT ON RALLY

Last week we looked at a descending wedge pattern on the S&P 500 chart that could have sparked a rally had it resolved to the upside. Prices actually did break upward, but volume was poor, and the up move stalled immediately. Now there is an ascending wedge pattern inside a declining trend channel. The technical expectation is for the wedge to resolve to the downside, but I should emphasize that it would only have short-term implications.

I am becoming more concerned with the medium-term prospects for the stock market. In late-October the market became extremely oversold by virtually every measure. This was a signal for us to start looking for an important rally. Since then, the oversold readings have been getting worked off as the market has been grinding sideways and lower. As you can see on the chart below, three of our medium-term indicators for price, breadth, and volume have been moving up and are relatively overbought (relative to their recent trading ranges).

On the chart of our OBV suite of indicators below, note that the medium-term VTO (bottom panel) is at overbought levels. The short-term CVI and STVO have also peaked in overbought territory.

Bottom Line: There has been a small rally out of the November lows, but volume has been weak. Deeply oversold readings have so far failed to deliver a rally of the strength and duration we would normally expect, and, with internals now becoming overbought, time is running out. The problem, I suspect, is that the only buyers are nervous short sellers. Once the shorts have covered, new buyers needed to continue the rally fail to materialize because nobody wants to buy this market.

RYDEX RATIOS DIVERGE

Decision Point charts a couple of indicators that are useful in determining investor sentiment based on actual deployment of cash into Rydex mutual funds. The Rydex Asset Ratio is calculated by dividing total assets in Bear plus Money Market funds by total assets in Bull funds. The Rydex Cash Flow Ratio is calculated by dividing Cumulative Cash Flow into Bear plus Money Market funds by Cumulative Cash Flow into Bull funds. (A thorough discussion of these ratios can be found in the Glossary section of our website.) When total assets in a given fund increase/decrease, the cause is an advance or decline in the fund's shares; however, there is also a component of the amount of cash moving into and out of the fund. This is why we have the two indicators.

On the Assets Ratio chart below, we can see that the Ratio is deeply oversold, implying that sentiment is very bearish, and that an important price bottom is being formed. This oversold reading is a direct result of the severe market decline depressing bull fund prices and inflating bear fund prices. The next chart shows a completely different picture.

While the Asset Ratio is oversold and bullish, the Cash Flow Ratio below is overbought and bearish. It is telling us that investors are quite bullish, and that a decline should be expected. That the two Ratios have diverged so severely is a very unusual situation, so let's take a closer look at what happened.

The next chart shows that, when the market began to consolidate, cash flowed out of bear funds and into bull funds. I can think of no other reason except that Rydex investors were anticipating a rally and trying to pick a bottom. This is bearish. I should emphasize, however, that the Ratios reflect the activity of a relatively small percentage of total market participants. Nevertheless, these indicators have a good performance record and are useful tools.

Bottom Line: The current divergence of the Rydex Ratios leaves us in a predicament as to which we should believe. In my opinion, the Cash Flow Ratio shows what is happening beneath the surface of asset totals, and it should be the first to be believed.

CHANGING WITH THE MARKET

When the market changes, we must change our tactics, strategies, and analysis techniques to accommodate the new market conditions. This is not a new idea, but it is one that is not very widely recognized, particularly when applied to the long-term. In recent writings I have emphasized that we are in a bear market, and that we must play by bear market rules. Overbought conditions will usually signal a price tops, and oversold conditions can often see prices slip lower to even more oversold conditions. When making these comments, my focus has been on the cyclical bull and bear markets. What I want to address in this article are the secular forces of which we must be aware.

On the chart below I have identified the five secular trends that have occurred in the last 80-plus years. First is the 1929-1932 Bear Market, which, although it was short, saw the market decline 90%. Next was a secular bull market that lasted from 1932 to 1966, which overlaps with the consolidation of the 1960s an 1970s. In the early 1980s another secular bull market began which peaked in 2000 (basis the S&P 500). Finally, we seem to have entered another consolidation phase that could last another 10 to 15 years.

I began my market studies in the early 1980s, before the big bull market took off, and I learned from the guys who learned all they knew from the market action of the 1960s and 1970s. Applying those rules to the new bull market was confusing, frustrating, and unprofitable. While I didn't participate in those markets, it is easy to imagine the bewilderment of those who, educated in the bull market of the 1920s, took the elevator all the way down to the basement starting in 1929.

The long bull market after the 1932 bottom was missed by most of those traumatized by the crash, but it trained a whole new group of analysts who learned that the market always goes up . . . until everything they knew was proven wrong by a 20-year consolidation. Finally, the battle cry of the 1980s and 1990s bull, "this time it's different," was learned well by those who ultimately ate the 50% decline of 2000-2002.

Unfortunately, it takes time to unlearn the lessons of the heady 1980s and 1990s, and we can still observe people using bogus valuation models that only work in bull markets. We still see people trying to pick bottoms, and we still see people who think that a stock is under valued because it is down 70%. By the time this current secular market phase is over, people will have learned all new rules, that will not apply to the next 20 years.

Whether or not I have correctly identified the current secular market phase as a consolidation remains to be seen, but I am certain that we are no longer operating on the rules of the last secular bull market.

VERY OVERSOLD MARKET

To say that the market is very oversold is not exactly breaking news because it has been oversold for at least a few weeks; however, the oversold condition has been steadily getting worse over that time, and we have perhaps reached the limit of how oversold the indicators will get without the market taking some time to clear the condition. Keep in mind that the condition can be cleared if the market merely drifts sideways while indicators drift higher toward neutral territory, but, considering the kind of volatility we have been experiencing, it seems that a rally is more likely.

Let's look at the chart below, which has some major points of interest. First, the PMO (Price Momentum Oscillator) and the Percentage of Stocks Above Their 200-EMA have reached their lowest points since the July 2002, which was the beginning of the end of the 2000-2002 Bear Market. Note that it took nearly nine months for this bottoming process to take place in the form of a triple bottom. Also, current prices have dropped into the support zone provided by that previous bear market bottom.

This all looks like a pretty good setup for at least a bear market rally of some substance. The first thing that has to happen is a rally the lasts more than two days, and we need to see if the bottom will be a "V" spike or a double bottom with at least several weeks between each bottom. The latter would be preferable because, the more work put into the bottom, the longer the rally is likely to last. A "V" bottom would beg for a retest.

Any rally that begins now should be viewed and played as a short-term event, because we have seen how quickly they have been running out of steam. The first indication that a rally may develop into something longer term will be if the Thrust/Trend Model generates a buy signal. On the chart below I have highlighted the two components of the T/TM that we need to watch -- the PMO (Price Momentum Oscillator) and the Percent Buy Index (PBI). When both these indicators have passed up through their moving averages, a new buy signal will be generated. Even though this is a medium-term signal, it should also be worked as a short-term event, because of the whipsaw we have experienced during this bear market. (The rally last long enough to trigger a buy signal, then fails.)

Finally, I am compelled to show you a chart of the 9-Month Cycles. My current projection for the next cycle low is October 22. As you can see, it is highly likely that the cycle low is already in as of last week, although we can never be sure except in hindsight. Nevertheless, the cycle chart is one more piece of evidence that we could be getting a sustainable rally at any time.

Bottom Line: The market is extremely oversold, and we have plenty of evidence that a rally is due. I do not for one minute believe the bear market is over, but it does not seem reasonable that the vertical descent will continue unabated. Reasonable? Perhaps that is not the best word to use in these circumstances. Let's just say that the technicals are screaming for a good sized bounce. Having said that, I will leave you with a reminder that we are playing by bear market rules. Oversold conditions are extremely dangerous and do not always present opportunities on the long side. Be careful!