Is the Rally Over, or Is It Just Taking a Breather?

There are two opposing sentiments feeding the U.S. stock market right now: On the negative side, the news from Japan and Libya is unsettling, but on the positive side, economic reports continue to reflect improvements in key aspects of the American economy's health.

It's a Wall Street truism that markets dislike uncertainty more than they dislike bad news, which is one reason why they have swooned recently: The long-term economic effects of Japan's devastating earthquake and tsunami, and of the civil conflict in Libya are complete unknowns, and each has the strong possibility of being negative for the U.S. economy.

Technical analysis offers a perspective on market action that is one step removed from the daily fluctuations triggered by world events. While some of the motions of the market are obviously news-driven, beneath the daily perturbations of good and bad news lay deeper patterns and trends which typically reassert themselves after the dust settles.

Going Up or Going Down?

Stripped of complexity, technical analysis boils down to this: identifying the current trend, and looking for evidence that the trend will continue or reverse.

This is why technicians look at moving averages (MA), which smooth out the daily ups and downs and plot the longer-term trendline. The longer the moving average timeline, the more weight is given to the trend it traces.

For example, let's look at a weekly (long-term) chart of the broad-based S&P 500. I've drawn two moving averages favored by many analysts, the 20-week and the 40-week moving averages.

When price remains above the 20-week MA, the market is in an unambiguous uptrend. When the 20-week MA is climbing above the 40-week MA, this reflects a solid uptrend: The shorter-term average is above the longer-term average.

Conversely, when the shorter-term average drops below the longer-term line, that reflects a weakening trend.

These moving averages tend to offer support for trends and resistance to reversals. The recent swoon, for example, tested the 20-week MA, dipping below that line, but closing above it by Friday. In essence, the 20-week MA acted as support.

Spotting the Turning Points

The commonly used indicators of relative strength (RSI), MACD (moving average convergence-divergence) and stochastics are all declining, indicating that there is weakness in the current upward trend. Yet the damage to price has been modest so far, barely denting the 2-year-old rally.

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Many technicians follow the 40-week cycle (that's about nine months). Observers have noticed that over time, the market often reaches highs or lows on this cycle. Nothing in technical analysis is written in stone, of course, and these types of overlays are notoriously easy to adjust to make them "fit" the real market's action. Nonetheless, it's instructive to apply a 40-week cycle just to see what might be revealed.

The first 40-week mark after the market hit bottom early in March 2009 didn't align with any distinctive top or bottom, but the next 40-week mark (early September 2010) corresponds remarkably well with the point at which the market exploded into a new uptrend. If this pattern has any meaning -- and it might not -- it suggests that the next near-term low in the S&P 500 might be about two and half months away, around early June.

That also corresponds with seasonal trends: The market tends to top out in spring -- hence the well-known advice, "sell in May and go away" -- and then decline, hitting bottom in the summer months.

One possible warning sign is that the upper Bollinger band has flattened and turned down. If we look at previous periods when the market has fallen, this same pattern emerges early in the decline.

In summary: On this long-term chart, the S&P 500 would need to drop decisively below the 20-week moving average before we would feel that the long-term trend was threatening to reverse.

Things Are Looking Down

On the daily chart, the recent market action in the S&P 500 looks a bit more bearish. The uptrend has been decisively broken, and the 20-day moving average is poised to cross through the 50-day MA -- a bearish cross which reflects that the short-term trend is now down.

Two of the three common momentum indicators -- RSI and stochastics -- have bottomed out near oversold territory and are bouncing modestly higher. MACD, however, has slipped below the neutral line and is still declining, suggesting the slump has yet to hit bottom. For the market to regain its constructive stance, price needs to climb back above the 50-day moving average (currently at 1,302) and the MACD trend indicator needs to reverse course and work its way back above the neutral line.

Filling the Gaps; Bulls that Bear Watching

Turning to the tech-dominated Nasdaq market, we find an even weaker technical snapshot, as the 20-day moving average has already made a bearish cross below the 50-day MA. The stochastics indicator has already reached oversold conditions that in the past have triggered a reversal, but what's different this time is the MACD, which is bearishly below the neutral line and still dropping.

Technicians have observed that the gaps formed when price opens strongly up or down tend to get filled in later, meaning that price returns to the area that was "jumped" and moves through the gap. An example of this can be seen in late January, when a gap that was opened by a leap upward in price was filled in about three weeks later when the market retreated.

Bulls have a reason to be hopeful for a gap-filling move from the market at the moment, because there are two open gaps right now above the current level -- one near the NADAQ's peak, and another just below the significant 50-day moving average. To fill these gaps, price will have to resume an uptrend.

However, on the bearish side, a longstanding gap just above the 2,500 level is waiting to be filled -- but to reach it would require a 140-point drop.

Technicians also look at sentiment readings, which reflect investor confidence and caution. Recent readings collected on March 15, four days after the earthquake and tsunami devastated Northeastern Japan, showed investor sentiment to be remarkably bullish, barely changed from the previous week, while bearish sentiment remained very low. Both readings suggest a complacency which technicians find worrisome: Complacency reflects a market vulnerable to trend reversal. At true market lows, bulls are scarce and bearish sentiment rises to extremes. When it comes to sentiment, bullish readings are not necessarily bullish indicators.