Reading the Charts for Clues to the Market's Direction

According to the Wall Street truism, the stock market is a discounting mechanism: News good and bad is quickly reflected in price movements. That's one basic explanation for the wild swings the market has been experiencing for the past few weeks: Bad news causes sharp drops, while more hopeful news triggers big rallies.

Another truism has it that the market looks ahead six months or so. If investors expect profits to rise in the future, they bid up prices, and if profits are looking iffy, then equity prices fall in anticipation of that disappointment.

Earlier in 2010, when profits were forecast to rise smartly, these expectations pushed the S&P 500 to a new high around 1,219. Then as the sovereign debt crisis in Europe gained speed, markets fell in anticipation of crimped future profits.

Rather than try to forecast whether corporate profits will exceed heightened expectations or disappoint in the second half, let's turn to a few basic technical charts for a (possibly) more objective view of where the U.S. market might be heading.

Let's start with a short-term look, the one-month chart of the S&P 500 (SPX), the widely used proxy for the U.S. stock market.

As I suggested was likely in my May 25 article, "Market Breaks Down But a Rebound Could Be Ahead," the SPX did rebound to the 1,100 level -- the long-term trendline of the 200-day moving average (MA). But as disappointing news on the euro and U.S. jobs front dominated headlines, the market fell back to the 1,065 level -- not coincidentally, the May 6 "flash crash" low.

After breaking down below the 200-day MA in the "flash crash," the market rebounded back up to the 50-day moving average, which at that time was about 1,170. This zig-zagging between moving averages is one reason why moving averages are valuable tools for investors to follow.

Moving average lines tend to act as support and resistance: When price falls, it tends to find support at key moving average lines, and when price is rising, it tends to encounter overhead resistance at these same levels.

We can clearly see how the 200-day MA acted as support until May 19, at which point it became a line of resistance. Since May 19, the SPX has punched back above the 200-day MA twice, but failed to move decisively above it.

If the S&P 500 can work its way above 1,100 and hold there, then technically there are reasons to expect a rebound to the 50-day moving average around 1,160.

Turning to an intermediate-term perspective, the six-month chart of the SPX, two things pop out: The 200-day moving average also acted as support and resistance in February, and the possibility that the market will trace a key technical pattern called "head and shoulders."

While any pattern resides in the eye of the beholder, chart-watchers have often noted a pattern in which a rise in price falls back to test some level of support, and then runs to a new high. After peaking, price drops back once again to the key support.

At this point, price often runs back up in one more bid to hit a new high. When price stalls at the same point at which the first uptrend topped out, then the pattern is called a "head and shoulders." We see the potential left shoulder and head clearly in this chart.

Interestingly, the left shoulder of this potential pattern created by the January rally topped out around 1,150 -- remarkably close to the current 50-day moving average around 1,156.

Chartists see two "magnets" for the SPX to rise once again to the 1,150-1,160 level: a test of the 50-day MA and a completion of the right shoulder in a classic head-and-shoulders pattern.

If the SPX does rally despite the gloomy news, the market's future direction will be telegraphed by how the S&P 500 acts around the 1,160 level: If it tops out there, forming a right shoulder, then a protracted decline could be in store.

If it breaks decisively above the 50-day moving average and climbs to the 1,175 level, then that renewed strength suggests a new bull uptrend will be in place.

Lastly, let's pull back to a longer-term view depicted by a two-year chart of the SPX. Once again we see how the 1,100 level has acted as critical support and resistance, going back to the global credit crisis crash in September 2008 and again in the bull market advance a year later in October 2009.

This suggests that 1,100 is an important "line in the sand" for the S&P 500. If it fails to advance above that line, then the market may be anticipating poor future profits. If the SPX advances above 1,100 and moves higher, then it suggests that major market participants have discounted the bad news about Europe, the Gulf oil disaster and the job market, and they still anticipate healthy U.S. corporate earnings in the second half of 2010.

Charts can't predict the future, but they can offer insight into the potential importance of certain levels of support and resistance.