Has the Stock Market Reversed Trend?

On Jan. 8, I made the case for one potential scenario of stock market action in 2010

: A rise in January that would be followed by a major sell-off that would then set the stage for a significant rally as the 2010 election approaches.

After the Dow Jones Industrial Average topped at 10,725 (intraday) on Jan. 19, the market fell over 800 points, reaching a nadir of 9,908 on Feb. 8. As of this writing (Mar. 4), it has recovered to 10,444, moving modestly above the 50-day moving average that I highlighted as a key technical level in my Jan. 29 snapshot of four key markets: China, gold, the U.S. dollar and the Dow Jones Industrials, which I use as a proxy for the U.S. stock market

While some feel the Dow 30 is too narrow to be representative of the U.S. stock market, both the S&P 500 and the NASDAQ have moved in close correlation to the Dow for the past year, so it's six one way and half a dozen the other.

Was the 800-point dip to 9,900 the correction many (including myself) have been anticipating for some time, or was it only the first leg down in a downtrend that has further to drop?

To see if basic technical analysis can shed some light on this question, I marked up a one-year chart of the Dow 30.

Technicians identify trends by drawing lines connecting the low or high points of price. The red line in the chart illustrates the obvious: The market was in a strong uptrend since March of 2009. Just as obviously, the market broke that trend line in its January decline.

If we draw another trend line through the lows traced after the July decline -- the blue line -- we find the market following a shallower uptrend. This suggests the market had lost some momentum and was rising at a slower pace. The Dow broke through this trend line as well in its recent swoon.

From mid-November through early January, the Dow was range-bound, trading in a narrow channel between 10,300 and 10,580. The trend line connecting the lows in this seven-week period -- the green line -- is essentially flat. This line was also violated when the markets fell in late January.

The Dow finally broke out of this trading range by breaching 10,600 on Jan. 7; 12 days later, it reached its high-water mark at 10,725. On the annual chart, this looks like a failed rally -- an attempt to start a new uptrend, which lasted less than two weeks and then rolled over into a sharp decline.

In breaking below trend lines going back to March 2009, the Dow also fell below the key technical support of its 50-day moving average (currently around 10,368).

Clear Warning Signs

Falling below trend lines and the 50-day moving average are clear warning signs that the uptrend may be reversing into a downtrend. Since the Dow recovered its footing, it has risen back into the channel where it meandered in November and December, between 10,300 and 10,580. In the bullish case, this marks a period of consolidation where the market builds a base for the next uptrend.

In the bearish case, this recovery to the area of support and resistance marks distribution, when large players sell (distribute) stock over time to avoid driving prices lower. Distribution provides a telltale sign: Lower trading volume on up days and heavier volume on down days. This has been the pattern for the past six weeks: volume rose when the market declined and fell on days it rose.

Head and Shoulders Pattern

While patterns are not predictive, many observers have noted that market tops have often traced out what is known as a "head and shoulders:" After consolidating at a certain price line (the left shoulder), the market rises to a new peak (the head) and then slips back to the previous consolidation area (the right shoulder).

As market watchers discovered in July 2009, what appears to be a head and shoulders topping pattern can instead turn out to be a correction in a long-term uptrend. There is no way to predict whether the U.S. stock market will consolidate around 10,400 and then begin a new march higher, or if this price level marks the right shoulder of a major top.

The definition of an uptrend is straightforward: Higher highs and higher lows. Conversely, a downtrend is defined by lower highs and lower lows. Right now, the Dow has traced out a lower low (9,908) and reached a lower high (10,466 on Mar. 3).

If the Dow is to resume its uptrend, it must begin establishing higher highs until it surpasses 10,725 and moves decisively above that level to carve out a new high.

If the market fails to make higher highs and dips below its 50-day moving average again, then the downtrend may continue. Were the Dow to fall below the recent 9,908 low, many observers would consider that confirmation that the uptrend has reversed into a downtrend.