TECHNICAL MARKET INSIGHT
By Mark Arbeter
Stocks: Breakdown Dead Ahead
S&P believes weakening technical signals over the last couple of years will lead to a major correction -- or bear market -- in the coming year
The major indexes are breaking down from the most recent highs, and we believe this could be the start of a correction that we have been expecting for the first quarter of 2006. The inversion of the yield curve has investors on edge, but we believe the weakening technicals over the last couple of years and the major cycle lows due in 2006 will be the overriding factors that will lead to a major correction or bear market in the coming year.
Advertisement
On Friday, Dec. 30, the S&P 500 broke below the most recent low of 1249.48 from back on Nov. 30 and it appears that the index is headed for an important test of the 1240 to 1245 area. This area is chart support from the highs posted back in August and September. An additional piece of important intermediate-term support is the 50-day exponential moving average and that lies at 1246. The S&P 500 has been above the 50-day moving average since November 2. The 80-day exponential moving average comes in at 1237 and is also considered potential support.
Longer-term moving average support lies between 1210 and 1223. trendline support, drawn off the peaks in August and September, sits at 1232. A 38.2% retracement of the advance from October to December lies at 1235 and a 50% retracement of the advance comes in at 1222. So at this point, we think there are plenty of potential support levels not too far underneath current prices.
On the upside, chart resistance, from the most recent sideways consolidation, lies between 1249 and 1276. Trendline resistance, off the most recent peaks, comes in at 1268. The 20-day exponential moving average or potential short-term resistance is at 1254. Daily momentum indicators, such as the stochastic oscillator and the moving average convergence/divergence, or MACD, have both rolled over from overbought territory. Daily RSI readings such as the 6-day relative strength index and the 14-day are not yet in oversold territory. Weekly momentum indicators are starting to roll over but have not given sell signals yet.
The Nasdaq, which has been a little weaker than the S&P 500 since Dec. 2 on a relative strength basis, took out its most recent closing low of 2222.42 from Dec. 20. The index has also completed a small head-and-shoulders reversal pattern. The Nasdaq also broke below its 50-day exponential moving average on Friday, Dec. 30, and this is the first time the index has been below its 50-day since October 28. Often times the 50-day moving average acts as support during uptrends and acts as resistance during downtrends. So far the break below the 50-day is not severe but, in our view, it is a warning sign that may indicate further weakness. The next piece of support lies at 2187 from the high posted back in September. The 80-day exponential moving average also lies in this area.
Longer-term moving averages, or potential support, come in between 2151 and 2107. The Nasdaq has already broken below a 23.6% retracement of the advance from October to December. The next Fibonacci retracement of 38.2% of the advance lies at 2182 and a 50% retracement of the rally sits at 2152. Like the S&P 500, the daily momentum indicators are negative while the weekly momentum indicators are rolling over but not yet bearish. One potential positive for the stock market is that this week's weakness occurred on very light volume. However, that is a function of the calendar as trading volume on the last week of the year is typically very light.
Cycle analysis points to problems for the market in 2006, in our view. Both the 39-week and the 78-week cycle lows are expected to occur late in the first quarter of the New Year. When these two cycles have occurred in the recent past, they have usually been a good indicator at predicting market lows. For instance, the last time these two cycles bottomed out together were in September, 2004, March, 2003, and September, 2001. All three times represented either major lows or intermediate-term lows.
In addition, the more important 4-year cycle low is due to bottom in the fall of 2006. The 4-year cycle has a strong record of accuracy, in our view, and therefore should not be ignored. The market has put in intermediate- to major market lows in 1970, 1974, 1978, 1982, 1987 (off a year), 1990, 1994, 1998, and 2002. Whether it will work again in 2006 is the question of the year as far as cycle analysis is concerned.
In our opinion, market sentiment is another potential dilemma for the stock market. The equity-only put/call ratio has dropped to levels that have generally preceded market pullbacks and corrections over the past couple of years. Usually before or as a correction sets in, the equity-only put/call ratio will reverse its decline and start to rise as bullish positions are taken off and bearish bets against the market are made. This is starting to happen right now as the 5-day ratio has been in an uptrend since the middle of December. The 5-day ratio typically leads the 10-day and the 30-day ratios and is a good early indication, we think, of a trend reversal.
Investors Intelligence poll of newsletter writers is once again tilting heavily toward the bullish camp, and from a contrarian viewpoint, we believe this is negative as we move into 2006. Bullish sentiment rose to 60.4% this week, the highest level since December, 2004. This happened to be right before the weakness that occurred from January to April of 2005. Bearish sentiment has fallen to an extremely low level of 20.8%, the lowest since August 2005. The market then corrected into the October, 2005, low.
Some of the other sentiment polls we monitor, including Consensus and MarketVane are also exhibiting high levels of bullishness toward the stock market. While sentiment can remain bullish for sometime, and the market can remain lofty within this environment, eventually sentiment will go the other way, in our view, taking the market down with it.
Arbeter, a chartered market technician, is chief technical strategist for Standard & Poor's
Market Data 
Markets 
AI
