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Lower Lows & Lower Highs: A Look At The Trend at Trader’s Narrative

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Stepping back a bit to get some perspective on the equity market, we find the S&P 500 index having exited a one year long uptrending channel. Going by the simplest definition, the trend is now down. Obviously you would know that by looking at a short term chart but the technical criteria has now been met: lower highs and lower lows.

I was interpreting the retracement in late May and early June as another correction based on previous indicators and patterns but that level has been broken. The simple price move isn’t the only thing that makes me change my view. We’ve seen both short term and long term technical deterioration in many underlying indicators for the market.

Unfortunately, trusted indicators that have faithfully pointed out oversold or overbought to us many times before can suddenly be thrown into disarray as the general context of the market changes. In this most recent example, oversold conditions persisted as price was unable to recover and extremes simply get more extreme.

So it is ineffective to use these same indicators to gauge where and when the next inflection point will arrive. Below I’ll highlight a few areas to watch as possible targets using other tools. As you’ll see, coming at it from several different angles provides us with confirmation that clusters around certain price levels.

Head and Shoulder Target
The first obvious technical formation that can provide us with a target is the head and shoulder formation on the S&P 500 index. Every single person who looks at this formation will draw the neckline slightly differently; either sloping down or flat. There are also long tailed candlesticks (the hammer candlestick formations we looked at before) making some use the intra-day lows and others the close of the day.

Click to see larger chart in a new tab:
S&P500 trend change Jul 2010

The shape, position and level of the neckline will make your head and shoulders probably look different than mind and ultimately that will make the target area to the downside slightly more or less. The way I’ve drawn mine provides me with a target at 900 for the S&P 500.

Fibonacci Retracements
When we’re looking for targets, the most popular tool for many traders is the Fibonacci retracement grid. The cyclical bull market was after all a retracement of the secular bear market decline, taking us from 660 to 1200 on the S&P 500 index - a picture perfect 61.8% Fibonacci level. Applying the same retracement analysis to the cyclical bull market itself we get a 50% retracement level of 950 and a 61.8% retracement of 880. The lowest level no doubt makes the bulls queasy but it coincides with the congestion area of support from summer 2009. The 50% level is also a natural support resistance line going back to the January and June 2009 tops (previous resistance that is now support).

Aftermath of Secular Bear Markets
Another framework is to look at the average price behavior in previous secular bear markets and look at how they have resolved themselves going forward. The “Rebound Rally” usually takes 17 months to play out and takes prices higher by 70%. Our recent experience isn’t off that mark too much with a 13 month rally that took prices higher by about 82%. What happens next is a correction that cuts the index by 25%. Using the April 2010 swing top as a starting place, that would take the S&P 500 index to 915. That is very close to the Head and Shoulder target area.

Death Cross
Technical analysts and traders seem to be hypnotized by the slow and inevitable arrival of the “Death Cross” just as fundamental analysts are mesmerized by the ECRI’s Weekly Leading index’s prediction of a “Double Dip”. The last time we saw the 50 day moving average moving below a 200 day moving average on the S&P 500 index was before Christmas 2007.

But it hasn’t arrived yet - at least not for the major equity indexes we usually watch. A “Death Cross” did occur on the NYSE index on June 21st 2010. While this is a classic index because it no longer purely represents common stocks, I’m not sure if it has the same significance it should.

Whenever it does arrive, based on historical precedence, this isn’t a terribly negative development. According to Ron Griess of the ChartStore, from 1930 to now when the S&P 500 has had a “Death Cross” with a still rising 200 day moving average, the one month average return has been -1.35% with 15 out of 28 instances being positive returns. Looking 6 months ahead, the average return has been +1.10% with 12 instances out of 28 being positive.

Dead Cat Bounce
Keep in mind that when something has everyone’s attention and convinced them with certainty, funny things tend to happen. This is especially important to remember now since, in the short term, the market is very oversold. Right now the RSI is at 31 and as you can see from the chart of recent market history, this has corresponded to market lows.

Click to see larger chart in a new tab:
RSI compared to SPX Jul 2010

However, the extent of the rally and its strength depends on the context of the market. Again, indicators act differently under different conditions. For example, throughout the 2008 bear market, the S&P 500 was only able to sustain very feeble rallies even from very oversold RSI readings. Then after the March 2009 low, the index was able to smartly rally even from relatively high RSI readings.

We’ve already seen two low RSI - early and late May. So this is the third in less than 2 months; not a very common occurrence. This makes me expect a short term relief rally. Sentiment is also reflecting quite a bit of pessimism - more about that in tomorrow’s weekly sentiment overview. But I don’t expect such a rally to be very strong or sustained. Especially if the earnings news that is coming out in a little while starts to disappoint. The mood right now is fragile and with summer vacations around the corner, Wall St. only needs an excuse to sell and ask questions later.

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4 Responses to “Lower Lows & Lower Highs: A Look At The Trend”  

  1. 1 Wes

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    Some other statistics on the death cross from the Woodshedder Blog show that in the last 50 years there have not been two consecutive profitable death crosses. There have been 8 consecutive losers in this time frame.

    Of the 25 crosses in this period, 8 were profitable, 17 were losers.

  2. 2 Frank Ochoa

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    Great write-up, Babak!

    One thing I find interesting is the fact that initiative sellers have yet to take over after testing price levels below the neck line of the pattern, which indicates the potential for a rally.

    Also to your point, since the entire market is watching this H&S, there is a crazy tendency to get a “Fake Break” that leads to a tremendous reversal.

    Let’s see how this shakes out!




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    Any chance of Mathew dropping by with a few words of wisdom ?

  4. 4 AB

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    One interesting image that I’ve discerned on that S&P 500 chart: A complete Elliott Wave cycle.

    First possibility is, the move from March 2009 - April 2010 is a complete bullish 5-wave cycle, with a B-wave correction in June-July 2009, and a D-wave correction occurring in January-February 2010. Since May we have experienced the bearish 3-wave cycle, with the B-wave correction (rally) occurring in early June; if this is the case, then we are in the 3rd and final wave of the bear cycle, and we should resume an uptrend here once we bottom.

    The second and more curious possibility is, we began a secular bull market in March 2009, and the move from March 2009 until April 2010 constitutes the A-wave, and the current drop from May constitutes a corrective B-wave.

    Remember, the rule for Elliott Wave is bull trend with 5 waves, bear trend with 3. And Head & Shoulders Tops are a typical feature of an Elliott Wave since the right shoulder constitutes a lower high and the peak of the corrective B-wave in the bear trend.

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