As the Bear Shows Its Teeth, Where Do Stocks Go Next?

stock trader
stock trader

With the Dow Jones Industrial Average ($INDU) down over 250 points Wednesday, and all the major indexes off about 2%, it's worth thinking about where the market is headed. Is this the start of the market crash many have been anticipating, or just another jarring bump in the rally's bumpy ascent from the July lows? Let's start by reviewing the market's unsettling roller-coaster ride over the past few months.

Back on June 30, when the S&P 500 was in free-fall, I made the technical case for stocks to rise sharply, based on a classic stock pattern called "head and shoulders."

From there, stocks rose smartly, but then plummeted sharply on July 16 in a severe case of the jitters. On July 19 I suggested that the Bull rally was still kicking, and a break above a declining trendline would prove it. Soon thereafter, I proposed that the market might be following an A-B-C-D pattern, and a downleg amidst a continuing rally would be the next step in such a progression.

Technically, the market is now at an important inflection point. If the market doesn't stage a reversal soon, the Bearish view becomes increasingly strong. A case can be made that the S&P 500's rise to the 1,130 level formed a "right shoulder" and thus a waterfall decline is to be expected.

A Bearish Break

If we look at a daily chart of the S&P 500, we can see that Wednesday's drop has wreaked major technical damage.

  • After bouncing between the 200-day moving average (MA) and June's high for six days, the market has sliced through the 200-day line of support like a hot knife through butter. In May and June, this presaged a steep market decline.

  • The uptrend has been decisively broken

  • Moving average convergence-divergence (MACD) has rolled over into a Bearish cross, as has the stochastic.

  • Failure to break above the June high is negative.

  • The 20-day moving average support has also been broken.

  • The key psychological level of 1,100 has been broken.

Given all these negatives, this chart gives Bears plenty of reasons to rejoice. There is precious little technical evidence here for Bulls to hang their hope on.

Bear Battles Bull

The past four months have been characterized by numerous big down days. This increase in volatility suggests an epic battle between Bulls and Bears continues unabated. Some of the big days down have launched a free-fall, while others have been countered a few days later by equally significant recoveries.

The strongest evidence that the Bullish case has not been vanquished is sentiment. A fatalism that stocks are doomed is increasingly prevalent in the financial media. The Bull-Bear ratio is still low, meaning that there are plenty of Bears and relatively few Bulls.

The market rarely rewards the majority. Contrarians have found that a preponderance of Bears generally marks market bottoms, and a spike in the number of Bulls usually marks tops. Based on this historical evidence, a case can be made that this panicky decline is more likely a brick in the "wall of worry" than the start of a cascade to new lows. There is no sure thing in the market, of course, and perhaps the multitude of Bears are correct in their anticipation of a major decline.

For a longer-term perspective, let's turn to the weekly chart of the S&P 500 ($INX).

Perhaps the most striking feature of this chart is the flattening of the moving averages over the past few months as the Bulls and Bears have battled to a standstill between the 20-day and 50-day moving averages.

A Big Break -- but Which Way?

If we draw lines from the April highs and July lows to the present level around 1,092, we get a wedge or triangle. Technicians have noted that stocks tend to break up or down in a major way from triangles. In a way, they reflect the battle between two opposing trends, and one will eventually overcome the other.

On the positive side, the MACD on this chart is rising and is poised to climb above the neutral line. But if the SPX smashes down through its 50-day moving average at 1,088 without pause, the Bullish case has been dealt a major blow, and the Bear case will be greatly strengthened. If the SPX ignores the ceaseless torrent of bad economic news and rallies strongly off the 1,088 line in the sand, then the rally may yet stage a "Rocky"-like comeback.

The Bears have numerous powerful technical winds and a veritable flood of weak economic news at their backs. The Bulls have a much weaker case based on the high levels of negative sentiment.

As many have observed over the decades, the market has an uncanny knack for foiling the expectations of the majority, be they Bull or Bear. Now that the market is in yet another free-fall and the news flow is decidedly Bearish, a comeback rally would certainly qualify as unexpected. The Bulls best hope may be that the bad news has been discounted and the line in the sand at 1,088 will hold.