The Bear Gains the Upper Hand

Price and volume trends suggest further weakness for stocks

By Mark Arbeter

The bearish trend is reasserting itself as the market is once again tracing out a series of lower lows and lower highs. The recent breakdown below important support by the S&P 500 and the Dow Jones industrial average suggests that the market is headed for another test of the July and October price lows.

In the very near term, it is possible for the "500" and the DJIA to put in a counter-trend rally back to the breakdown areas. For the "500" that would be a move back to about 870 to 875, and for the DJIA, a reflex rally back to the 8160 to 8215 zone.

Many times, when an individual stock or index breaks out of a consolidative pattern, the breakout point is tested. If it is a bearish break, and the previous trend was lower, momentum to the downside will shortly develop. This also pertains to bullish breakouts. In a bear market, it is usually a good time to initiate or increase short positions. In a bull market, a successful test of the breakout point is usually an excellent time to initiate or increase bullish positions.

There are certainly other price patterns that can develop after a bullish or bearish breakout. Once the break occurs, the index or stock can just keep going. This is more likely to happen with high beta stocks. The other price pattern that can develop is a failed breakout where the stock or index quickly moves counter to the prevailing trend and moves back into the consolidation area. When this price pattern develops after a bullish breakout, it is usually not a good sign and when a price breakdown fails, it is usually a fairly bullish signal.

While the overall trading volume continues to run from average to below average, depending on the index being monitored, there remains a clear pattern of distribution by institutions. All of our volume breadth indicators are in bearish configurations and that always suggests that caution is warranted.

Looking at some of the worst bear markets during the last century, volume usually declines the longer the bear market lasts and then explodes when a new bull market gets started. Light volume is quite typical during a structural bear market, and occurs during both counter trend rallies and declines within the bear market. In the early stages of a bull market, volume will be much higher than average, and in some instances, have actually set all-time highs just as the advance is getting started. Obviously, that has not transpired as of yet.

Sentiment measures remain stubbornly bullish, despite the lackluster performance by the equity market. Investors Intelligence poll of newsletter writers is still showing 50% bulls (for the third week in a row) and only 26.1% bears. Bearish sentiment has been below 30% for 14 straight weeks while bullish sentiment has been up near 50% for the last 13 weeks.

It remains a mystery why sentiment would remain so bullish during a period when stocks were either flat to down, and after a 3-year period of steadily declining prices. Option players have also been making bullish bets as the CBOE put/call ratios have declined to levels, which have preceded price weakness.

Another sentiment indicator, the VIX or volatility index is flashing warning signs as well. The VIX measures option premiums and is therefore known as the fear gauge. During the past week, the VIX rose above 35 (it actually hit 40.89 intraday on Monday, Jan. 27) and that has been a danger sign in the past. An increase above 35 has often preceded many major intermediate-term declines. During the last couple of years, the VIX has given very good buy signals when it has reached an extreme of 50+. For the index to get this high, you rally have to have some major downside momentum develop over at least a three- to five-day period. This price washout occurs at the very end of most intermediate-term declines.

The action of other markets, including the U.S. dollar, the Commodity Research Bureau index, gold, and oil, remains negative for U.S. equities. Even the 10-year U.S. treasury bond is back below 4%, showing little market faith that a strong economic revival is taking shape. One foreign stock market that usually moves with or before the U.S. market is the FTSE 100. The FTSE fell to a new bear market low this week, eclipsing the lows it had put in during July and September of 2002.

The movements of these other markets bear watching and are not sending a particularly positive signal at this time.

Arbeter is chief technical analyst for Standard & Poor's

Before it's here, it's on the Bloomberg Terminal.