Sunday, May 23, 2010

Why I Think Stocks Are Topping and Headed Much Lower

It's always good to take a step back and look at the forest from the trees when analyzing the stock market. In other words, the longer term timeframe dictates the shorter term movements. The market has been extremely volatile the past month as traders and investors realize that things are in fact, not all right in the world we live in. From countries on the verge of defaulting on their debt in Europe as a result of years of reckless spending and declining productivity to sudden fears of a major slowdown in the global growth leader, China. Financial regulatory reform. A devastating oil spill in the Gulf sure to bring debates against deep water drilling and big oil. Higher taxes courtesy of the Obama administration. And stubbornly high unemployment.

Since the S&P 500 bottomed in March of 09 at 666 the bull market run has taken us up to 1219 as of late April, a move of 83% with other sectors seeing even higher returns during this time. In just the last 4 weeks the SPX has fallen back to 1055, a correction of over 13%. There has been a lot of technical damage to the chart and this is evident across most sectors, especially financials and materials. The technicals have been warning of a correction of this size for awhile now and looking at the longer term weekly charts I think they are starting to point towards a topping pattern that is developing over the course of several months and should drive us into another bear market by the start of Fall 2010, if not sooner. The highs we saw in April at 1219 have a good shot of holding as the highs for the year and if not then only slightly newer highs should be seen and that will be an outstanding selling opportunity before the cake hits the fan.

If you look at the charts shown I believe we are forming a bearish head and shoulders pattern that likely just formed the head and we should see a weak right shoulder form during the next few months going into summertime. The key to this pattern is that the next few months form a weak grind back up similar to March-May of 2008 and not surpass much more than 1180-1200 on the SPX. If we move up with strength and even make new highs for the year then odds are that we simply just formed the left shoulder of this topping formation and the head will take longer and top higher than the 1219 high. Nevertheless I do think the upside for the remainder of 2010 is limited and if we break the 1044 lows from Feb then we should likely see a steep selloff down to 943 which marks the 50% retracement of the entire bull run from March 09. Below that the 61.8% retracement shown in the chart is near the July 09 lows at 875 and would be the ultimate target by the end of 2010. This is not as crazy as it sounds and I fully expect that level to be hit if we do indeed breakdown from 1025.

Zooming in closer on the daily chart I have marked the neckline of the head and shoulders top I believe we are forming and that measured move from the neckline of roughly 1060 to the high of 1219 is about 160 points in the SPX, which brings us to a target of roughly 900. This massive selloff would bring us back to the July lows where we have an unfilled gap at 906 just waiting like a magnet to be filled. I'm a huge believer that all gaps eventually get filled in the SPX, even if sometimes it takes a year. This would be a logical area to see the market trade down to once support is broken at 1025.

This is a longer term 6 month view and I do think that over the next few weeks and months the market actually will rally and begin to start looking more positive and you'll probably even hear it from the media. But underneath the hood I think the health of the market will be deteriorating and fewer stocks and sectors will be making new highs and participating in the potential upside. By the end of summer or early fall I think it will be clear that stocks are in a bear market.

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