Markets Facing Another Important Test

If the S&P 500 and Nasdaq break below the range set on Apr. 18, it could spell trouble

By Mark Arbeter

The market action remains negative and if the major averages don't turn quickly, a test of the March/April lows could be in the cards.

We have mentioned in the past that support and resistance areas can be created in a couple of different ways and they include sideways price action and heavy volume days. Because of a couple surprise moves by the Federal Reserve this year, heavy volume days are becoming more and more prominent for determining key support and resistance levels. On Apr. 18, when the Federal Reserve surprised the market and cut interest rates, stocks soared on the second heaviest volume in history. The rally for the S&P 500 began at 1192 and the surge for the Nasdaq started at 1923.

The Nasdaq, it should be noted, created a gap on the 18th so the support we are watching contains the entire area the gap. The rallies during the 18th went to 1248 on the "500" and 2129 on the Nasdaq and so the entire days range represents very good support.

Because the volume was so heavy on the 18th, there is a vested interest by many market participants in that day's range. The same was true on Jan. 3 when the Federal Reserve surprised the market and created the heaviest volume in history for the Nasdaq and what was at the time, the heaviest on the NYSE. After the market fell below the range set on Jan. 3, that area became resistance and halted the advance in mid-May like a brick wall. If the indexes break below the range set on Apr. 18, this zone will then become resistance or overhead, and be one more obstacle for the market.

While the lower boundary of support was tested on July 6 for the "500", the Nasdaq still has a ways to go. To confirm a breakdown, the indexes would have to close below the 1192 level for the "500" and 1923 on the Nasdaq for either 2 days or by a couple percent. If that were to happen, the next level of support would be the recent bottom area created during the March/April lows or 1081 to 1183 for the "500 and 1620 to 1962 for the Nasdaq.

As we said in our last comment, chart patterns are negative on a short-term basis. Both the Nasdaq and the "500" traced out head-and-shoulders tops and these patterns target downside levels of 1850 for the Nasdaq and 1180 for the S&P 500. One positive that is developing is that some of the major Nasdaq components are testing or getting close to the lows seen in April. Many other Nasdaq stocks remain in bases that began last October. We said in the past that major bottoms are not formed quickly after major declines so it is positive that these bases are getting longer.

However, looking back at historical patterns of stocks that have soared and then crumbled, it can take years of basing before these stocks ever move into any kind of sustainable uptrend. So patience is definitely key with respect to the technology sector.

Whether the indexes continue lower or not, there has been a nice switch in some of the sentiment polls we monitor. The American Association of Individual Investors poll has shown a dramatic turn to the bearish side, a positive from a contrarian viewpoint. Bullishness has declined to 30% from over 60% in May, while bearish sentiment has risen to 33% from a low of 17%. The Consensus Poll has seen bullish levels fall from 66% in May down to 37%. However, these polls tilted much more to the bearish side at the March/April lows.

Put/Call ratios have not yet moved to areas that would suggest fear is building among option players so some more downside action might be in store. Also, volatility indexes have declined to very low levels which suggests a lot of complacency in the markets and so these indexes are also pointing to the possibility of more downside.

While the latest weakness may have been exacerbated by the light trading volumes during the holiday week, and certainly by the mountain of negative Q2 preannouncements, which should end soon, we remain cautious about the near-term. The other potential negative is that the seasonally weak September-October time period is just around the corner.

Arbeter is Chief Technical Analyst for Standard & Poor's

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