Stock Market Technical Signs Point to Heightening Risk

The key feature of technical analysis of the stock market is simple: It doesn't look at so-called fundamentals like news, price-earnings ratios or any other financial data. It looks only at price movement, at so-called internal indicators such as volume and at various levels of support- and resistance-price levels, which over time have often proven to be significant.

Right now, the technical signals in the U.S. stock market are extremely negative, and it behooves all investors to look at this evidence before making any investment decisions. Let's look at several key technical indicators.

The VIX volatility index is rising. I have reported on the VIX recently-and true to form, it is now clear that the VIX was indeed flashing a warning sign to market exuberance. Now it is signaling a reversal of trend, meaning the year-long rally appears to be over and a new trend down has begun.

As we can see in this chart, the VIX declined steadily as the market (the S&P 500) trended higher from its March 2009 low. Then it reversed its downtrend and has been rising as the market has slipped.

The market failed to breach the long-term 200-day moving average (MA). Technicians use moving averages to denote trends, as a moving average smooths out the daily noise of small moves up and down.

Since these are averages, the levels change with the time frame. If you pull up a long-term chart of the S&P 500 (just click on the S&P 500 in the banner at the top of the DailyFinance page, select "technical charts and then select "3 years" as the time frame), you'll see that the 50-day moving average is around 1,073. (There are two kinds of moving averages, "simple" and "exponential." Both do the same work of providing a trend line, but each will generate different lines.)

Any break below the 50-day moving average is considered very bearish. In effect, the 50-day MA is a widely recognized "line in the sand." If price drops below that line, many trading systems will issue a sell, regardless of the headlines or earnings reports.

On most charting systems, the 200-day moving average of the S&P 500 is around 1,220. Market technicians found it extremely important that the market touched, but could not stay above, this key technical level at its recent top.

If we move to a short-term chart, like a one-month view of the S&P 500, we find the moving averages are roughly 1,102 for the 200-day MA, 1,173 for the 50-day MA and 1,167 for the 20-day MA, which acts as a sort of "close-up" of market trends.

A break below the 50-day level is considered bearish, and a break below the 200-day MA is viewed as extremely bearish.

Typically, markets will bounce off these key support levels or return to test them before breaking decisively through to a new trend, be it up or down.

Thus, we can anticipate that the S&P 500 will probably rebound back up to the 1,100 level -- a key "line in the sand." Failure to do so would confirm a bear trend.

Technical analysts discern various patterns in price action, and I've indicated one common one here: The A B C D pattern that tracks the jagged trending up or down that's often seen as markets work their way higher or lower.

The basic idea is that A marks the recent top, B marks the initial drop to a new low, and C marks the rebound. The pattern requires that C does not exceed A. That is, that the rebound rises to a lower high. If the pattern holds, the D leg down will take the market significantly lower.

This pattern can be seen on the way up to a top and on the way down to a final bottom.

Our last chart is a close-up of recent price action. The important pattern shown here is what's known as a "cross": The 20-day moving average has crossed below the 50-day moving average. This reflects a major change in trend.

Bull markets are confirmed when the 20-day MA crosses above the 50-day MA. Bear markets are confirmed by the reverse, which is what we see here.

When the 50-day moving average crosses below the 200-day moving average, it's commonly called "The Cross of Death" because this pattern has been followed by deep, enduring bear markets.

Some respected analysts find it technically significant (in a bearish way) that on May 18 the market closed below the May 6th "Flash Crash" closing price.

Others note that volume has been heavier on down days than up days, which is yet more evidence that sellers are taking control of the market action.

Combine these negative charts with the precarious fundamentals of the U.S. economy, which I covered here recently, and a sobering picture of heightened risk takes shape.