Channeling Past Stock Market Declines

Over the past several weeks, the markets have presented what has seened like extreme volatility; or is it? And what does it mean when the stock market swings within a wide range? We'll look at that below.

First: The story behind the charts

Since the stock market made a low about six weeks ago, we have seen seven distinct swings in both directions. That has occurred in a 1000 point range on the DJIA, between 10,600 and 11,600. For most market participants, this has been a period of whip saws and frustration, as momentum trading, which historically bears the most fruit, has not been working.

The rallies off the bottom of the range are coming as fund managers find value in depressed stocks. There is constant discussion of over $100 earnings projections for the S&P 500, historical low PEs and $2 trillion of cash in corporate coffers. So the market has looked cheap. When value investors step in, and a rally starts to develop, the media looks for reasons for the improved tape and reports some event in Europe that indicates cooperation may save Greece from default. So the stock market get pushed towards the top of the range.

The selloffs appear as the rally lasts a few days and profit taking comes in. Then, all of a sudden, the Euro zone situation is bad again, the euro currency is falling or there is talk of world-wide recession, a Euro bank crisis or a China slowdown. Gold then starts to fall as it seems one way out is for Euro-zone countries to sell assets, like precious metals, to raise the needed cash. And the stock market falls to the bottom of the range; with the cycle starting all over again.

This market action has created a "channel" on the charts. The recent swings do seem wide, with the range being about 12% from low to high. Historically this type of bounce off the low, in a declining trend, is not excessive. Please look at the chart below; the 2011 Market Top. This is a weekly chart of the S&P 500. I have drawn in the channel in which stock market has traded over the past seven weeks. This pattern is a "bear flag" or "pennant". These formations are shaped in a counter-trend direction and are usually consolidation patterns. The odds strongly favor coming out of the pattern in the same direction which the market came in; in this case, down.

 

 

S&P 500 Weekly Chart Courtesy of TD Ameritrade

Now please look at the next chart; a weekly S&P 500 of the 2007-2009 bear market. You can clearly see that bear-flag patterns occurred three times in that major bear market; with rallies between 9.5% and 27%. Each one of those negative patterns ending in very sharp sell-offs. Also note that they all came with the S&P 500 below its 40-week moving average; just as the market is now.

I can go back in history and a multitude of declining market periods with very similar formations; many in the bear markets of the 70s. Almost every one resolves on the downside. This pattern has over a 70% probability of working; quite high.

 

 

S&P 500 Weekly Chart Courtesy of TD Ameritrade

The next chart is one of my favorites, as it illustrates one of the most consistent cyclical patterns I have come across. I used this type of (cyclical) analysis in my September 22, 2010 Green Faucet article, "The Stock Market's Next Big Move", in which I correctly predicted a 100 plus point rally in the S&P 500. Please refer to the chart of the Monthly Dow Jones Industrials below.

This is a 7-year chart which contains the last bull market that began in 2002, the following bear market that bottomed in 2009 and the present bull market and correction. I have separated the monthly cycles with blue verticals bars. A cycle is measured from significant low to significant low. Note that there is a very consistent cycle pattern that repeats every 16 to 18 months. Though I have showed seven years, this repeating pattern actually goes back much further.

The present cycle is 14 months old. That makes the probability quite high that there is another two to four months left before this monthly cycle bottoms. That means the low the stock market made on 8/9/11 will likely be taken out before this declining phase is over, probably by a significant amount.

 

 

Monthly Chart Dow Jones Industrial Average Courtesy of TD Ameritrade

I am not declaring this to be a bear market; yet. In fact, it is still likely that this is a secondary correction in the ongoing bull market that began in 2009. However, if the S&P 500 index breaks the major support at 1010, coinciding with the major corrective low on DJIA low at 9614, a bear market will have been confirmed.

For now, based on the very negative the short-term bear flag and the longer-term bearish cyclical pattern; it's very dangerous to be expecting the stock market's next major rally to begin at this time; and any rally should be held in suspicion.

In a few months, assuming major supports hold, we'll be looking at a different scenario, as negative patterns will have been resolved and we will be entering into a much more favorable period for the markets.