With Stocks at a Key Technical Level, What's Next?

New York Stock Exchange
New York Stock Exchange

Back on June 30 when stocks were swooning, I suggested that the broad-based S&P 500 stock index might rebound to around the 1,150 level -- a target it reached on Friday, Sept. 24. The basis of this call was a technical-analysis pattern called a "head and shoulders," which is characterized by a peak bracketed on either side by a lower high.

Having hit this target, the S&P 500 is now at a key technical level. Will it fall back, or continue marching higher to the next technical target around 1,200?

The answer depends on how the market responds to the avalanche of key data on the economy this week.

Though technical analysis cannot foretell the future, it can help us discern certain scenarios that may play out going forward. Considering such possibilities helps us revise our investment and trading plans. For instance, in late April I suggested that the low reading in the VIX volatility index was sending a warning about a potential reversal in the bullish trend -- a reversal that began a week later on May 6.

The VIX Is Flashing "Caution" Again

If we pull up a weekly chart of the VIX index, the first point of interest is the extreme low in the stochastics reading.

Indeed, the last time the reading was this low was in late April, right before the market reversed on fears of a European debt crisis.

The MACD (moving average convergence-divergence) lines have been drifting down, suggesting that market complacency is returning, along with modestly "good news" in recent readings on the global economy.

The VIX (currently around 21) has yet to hit the April lows around 16, but it has dropped to levels that historically have signaled confidence in market stability has gained ground.

Ironically, it's just this sort of confidence and complacency that sets up market reversals if a "negative surprise" jostles investors with unexpected "bad news."

On the other hand, the VIX slowly drifted lower for months after the market nadir in March 2009, so there's no technical reason it can't remain low for an extended period. The chart does suggest caution, however, because lows in the VIX correspond to highs in stock valuations, just as spikes up in the VIX align with market lows.

A Mixed Picture in the S&P 500 Charts

To get a well-rounded technical view of the U.S. stock market, let's look at the S&P 500 index in two time frames: one that covers the past six months, and a longer-term chart of the past three years.

On the long-term chart, we see the effects of the 2008 global financial crisis: The index plummeted from 1,300 to 667 in a few dismal months. The global recovery is reflected in the uneven but steady rise from the March 2009 lows to the April 2010 high above 1,200 and the range-bound trading since then.

We can also discern the "head and shoulders" pattern described earlier: The "right shoulder" is now complete. This is potentially worrisome to bulls because head and shoulders patterns often mark a top in the market.

But any pattern is just a suggestion of one possible future. The market could break out of the head and shoulders and reach for new highs. On the positive side, relative strength (RSI) is not at an extreme, MACD is rising modestly and the stochastic reading has reached oversold levels, which is potentially bullish.

If the index can break above the long-term resistance offered by the 20-day moving average (the red line), which sits almost exactly at 1,200, that would be a very bullish technical signal.

However, low volume must be placed on the bearish side of the ledger. The saying on Wall Street is "volume is the weapon of the bull," because rising volume indicates strong demand, which will soak up all selling and bid stocks higher.

Another potentially vexing pattern comes into play if the SPX does climb above the 1,200 level: Were stocks to reach the previous peak around 1,220 and then fall sharply, that would trace out a double top. This pattern is often observed at market peaks.

Why would this be dangerous to bulls? When a market reaches a previous high-water mark but can't muster the oomph to push decisively through to new highs, then participants will sense weakness and respond by selling to take profits. That unleashes additional selling as stop-loss sell orders are triggered, and an avalanche of selling can ensue.

The 200-Day Moving Average Is Key

Turning to the short-term chart, bullish signs abound: The index has broken above the key resistance offered all summer by the 200-day moving average (the red line), an uptrend is clearly in place, MACD and the 20-day moving average are both rising strongly and the stochastic indicator is maintaining bullishly oversold levels.

However, warning signs include an RSI that's approaching oversold levels that may signal an extreme of sentiment has been reached. Another red flag is that low volume, which suggests fuel for a sustained rally is still lacking.

As a reminder of the dangers of overemphasizing any one technical signal, notice that the heavily hyped "cross of death" in early July (the 50-day moving average plunging through the 200-day moving average), supposedly a super-bearish signal, actually marked the moment to buy.

The picture formed by all three charts can be summarized as cautiously bullish, with a VIX-colored dash of uncertainty. If the market can decisively breach the 200-day moving average with increasing volume, then the VIX's warning signs can be pushed into the background.

Though no one indicator "rings a bell" at the top or bottom, the VIX remains a reliable guide to limiting risk to the downside. The VIX's low reading suggests that if the market registers any disappointment in the upcoming data, then a reversal of fortune could occur.