A Breakout Is Likely -- but in Which Direction?

A variety of technical signals are suggesting we're at a crucial decision point for the stock market: Either the bull recovers from its recent swoon and moves decisively up toward new highs, or the market reverses trend dramatically and moves down.

Although many market observers dismiss technical analysis as unscientific speculation more akin to astrology than math-based quantitative analysis, those skeptics are missing the point: Technical analysis isn't rooted in brute-force matching of curve sets, it's rooted in human psychology. Levels of resistance and support are not mathematical certainties -- they reflect the human psychological tendencies toward greed and fear.

When the market finally recovers a key level, for example, those investors who have grown weary of being underwater simply want their initial capital back, so they sell. This creates resistance. When the market declines, those who have reaped gains from buying during previous dips will jump in and buy more stock at what they perceive as "bargain" prices. This creates support.

And proponents of number-crunching quantitative analysis shouldn't be too cocky about their tool of choice: Quant analysis is based on past price action and patterns just like technical analysis. Just because a math-derived curve set matches recent price action does not preclude the unexpected from happening. This is why quant-based funds such as Long-Term Capital Management tend to self-destruct when markets trend strongly in unpredictable ways.

There are a lot of crosswinds in the market right now. Gains in retail sales and jobs are trends that support a bullish stance, while rising oil prices, food inflation and geopolitical uncertainty are giving credibility to a more cautious or even bearish perspective.

Warnings from Carl Icahn and Bill Gross

Small investors often look to highly successful "superstar" investors for hints on where the market is heading, and two recent news items about such big names have provided solid support for the bear camp: Legendary investor Carl Icahn has dissolved his hedge fund and is returning its capital to shareholders, citing the risk of another financial crisis. And famed bond manager Bill Gross has reduced the Treasury bond holdings of the world's largest bond fund, Pimco's Total Return Fund, to zero. The amount of cash the fund holds has swollen from $11 billion to more than $54 billion, its largest cash position ever.

There isn't any other way to interpret this except as a multibillion-dollar bet against the Federal Reserve's reassuring stance that inflation will remain tame for years to come. If you fear inflation might accelerate, the last investments you want to own are long-term, low-yield bonds that will instantly lose money if interest rates start rising.

Some analysts also interpret this move as an expression of doubt that the Fed will launch a massive third round of quantitative easing in June when the current QE2 campaign is scheduled to end. The Fed's ongoing $600 billion quantitative easing program is widely regarded as having strongly supported the rising equity markets.

As for the rising retail sales numbers, part of those "gains" can be attributed to rising costs: People and businesses are paying more than before for the same goods. If households are spending borrowed money again, that's not a sign of strength -- it's a sign of weakness in the household balance sheet. Consumers turned on the credit card spigot again in December, and they've loaded up on car loan debt this year.

What analysts should be looking at is whether household incomes are rising. Unfortunately, the answer is clear: Wage earners aren't benefiting much from the recent strong gains in productivity.

In an economy based on consumer spending, stagnant household incomes don't provide a strong foundation for future spending increases.

As for stock valuations, by at least one analyst's reckoning, many stocks are at all-time highs. Does the underlying economy support sky-high stock valuations? That's an open question, and one the market is obviously pondering.

To round out the backdrop for the market's current indecision, let's look at these two log-term charts of the S&P 500 and the Nasdaq.

The Nasdaq has retreated from the highs last reached in 2007, following a pattern that looks a lot like a classic "double top."

The S&P 500, meanwhile, traced out a massive double top pattern earlier in the decade. Its rapid ascent from the 2009 lows has been far more robust than the recovery in the overall economy, a disconnect that the current market queasiness reflects.

Now let's look at the daily chart of the broad-based S&P 500 (SPX).

The push and pull of hope and doubt is visible in the wedge (also called a flag or pennant) that has been traced out over the past three weeks. This is a classic wedge of lower highs and higher lows as prices are squeezed into a narrowing band of volatile swings.

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Wedges are typically broken by big moves either up or down. A collapse in oil prices or a strong jobs report might provide the catalyst for an upside breakout, while accelerating inflation, a further rise in oil prices or a weaker-than-anticipated jobs report might trigger a breakdown and a trend reversal.

The 1,300 level offers both a psychological and technical support -- a round number and the 50-day moving average. Any sustained break below 1,300 would signal a possible trend reversal.

The bull has stumbled recently. For it regain its footing, the market would need to climb above the 20-day moving average (MA) and then retest recent highs around 1,343.

The two-month chart of the Nasdaq offers an interesting technical snapshot of indecision: As fear that the rally is over takes hold, the market drops significantly. Then as "bargain-hunting" and hopefulness return, it moves back up to the 2,800 level. But then by day four or five, doubt returns with a vengeance, and the market plummets again only to retrace back up to the 2,800 zone of resistance a few days later.

Now that pattern is breaking down: Price has failed to climb back above the critical 20-day moving average even as it has turned down, and is now clinging precariously to the key 50-day moving average. A break through the 50-day MA would be technically significant.

Nobody knows what the market will do tomorrow, much less three months or three years from now. But to the degree that markets reflect the emotions and calculations of its human participants, the current indicators of doubt and indecision deserve careful watching.

Disclosure: The writer has a small position in ProShares UltraShort QQQ (QID), an inverse ETF on the NASDAQ 100.