More Signs of Weakness

With technical conditions deteriorating, there is a good chance for a 10% correction in the S&P 500 from its recent high

By Mark Arbeter

The stock market exhibited additional signs last week that the major indexes are in the early stages of an intermediate-term correction. The topping process usually takes time and can be very frustrating in predicting, unlike intermediate-term bottoms, which usually occur very rapidly with a real price washout.

The S&P 500 is further along in completing its topping formation than the Nasdaq. The string of events that occur when an index puts in a top is well advanced for the "500". The index has taken out its main, intermediate-term up trendline as well as its 50-day moving average. During the past week, the index made a minor break below its two-month trading range at 974.50, with its close of 965.46 on Aug. 5. The S&P has since rebounded back to its breakout point in the 975 area, which is now resistance, and stalled.

This break through support, followed by a rally back to the breakdown point is a quite common chart formation and usually leads to a price failure. If the "500" can rally back into its two-month trading range, then the correction we see will be delayed, but still likely.

Potential areas of support for the S&P 500 when some downside momentum exerts itself begins with the 965 area, which was the top of the massive trading range that the index inhabited from July, 2002 until May, 2003. Additional chart support lies at 950, 930, and then 900. A 38.2% and 50% retracement of the advance since March, which are typical during a correction, come in at 930 and 900 respectively. A measured move, based on the width of the two-month price consolidation, would target the 937 level.

The Nasdaq is still in the process of tracing out a bearish reversal formation, but is starting to underperform the "500" -- not a good sign. The recent weakness in the index relative to other indexes goes hand-in-hand with the breakdown of many of the leading stocks during the run since March. Many leaders have rolled over and broken below their respective 50-day moving averages and this is always a real warning sign that things could get dicey over the next month or two.

The Nasdaq broke its intermediate-term up trendline, and just last week, made a minor break of its 50-day exponential moving average. To complete its reversal pattern, the Nasdaq would have to close below the 1600 area. Levels of support for the Nasdaq begin with chart support at 1500, and then 1400. A 38.2% retracement of the advance comes in just below 1600 while a 50% pullback of the rise lies just above the 1500 area.

Another technical negative that seems to be gaining steam is the weakening condition of the markets' internals. The NYSE advance/decline line has broken its strong up trend and has rolled over to the downside. There has been a big reversal in our accumulation/distribution models on both the Nasdaq and the NYSE, and for the first time since January, these are in bearish configurations.

In addition, there has been a big break in the number of new 52-week NYSE highs versus new lows. The difference between new highs and new lows on the NYSE peaked at 580 on June 6. Since that time, there has been a large drop in the number of new NYSE highs with the number of new lows just recently exceeding the highs. There has been a negative moving average crossover of this data with the 20-day falling below a declining 75-day exponential moving average. A similar sell signal on the Nasdaq new high, new low chart can be seen using a 20-day and 45-day exponential moving average.

As illustrated many times in past weeks, sentiment remains heavily weighted towards the bullish camp -- and this is a major warning sign. The investment polls continue to show high levels of bullish market sentiment despite the recent weakening momentum of the major indexes. The volatility indexes (VIX, VXN) remain at very low levels showing a great deal of complacency. The VIX recently closed below the 20 level for the first time since last March, and it would be very negative if the VIX starting rising and closed above 25.

Meanwhile, CBOE put/call ratios, after moving to very low levels back in the middle of June, have started to rise. The 10-day and 30-day exponential moving averages of the CBOE put/call ratio have been moving steadily higher since the end of July, and may be signaling trouble for the equity markets. After moving to very low levels that have been associated with trouble in the past, the put/call ratios will frequently start to rise before there is major price damage in anticipation of a market decline.

With the weakening price momentum along with deteriorating market internals, and a poor seasonal backdrop for equities and a high degree of investor optimism, there is a good chance for a 10% correction in the S&P 500 (off the recent high) by mid-October and a decline of 15% or more in the Nasdaq. This would equate to about 900 on the "500" and 1500 on the Nasdaq.

Arbeter is chief technical analyst for Standard & Poor's

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