Ripe for a Reversal

S&P believes that the market has additional downside in this seasonally weak period

By Mark Arbeter

The stock market had a tough week, as the major indexes all fell back to important, short-to intermediate-term support levels as another major hurricane bore down on the Gulf Coast. With many indexes and individual stocks tracing out bearish reversal patterns, we believe that the market has additional downside in this seasonally weak period.

Bull market tops have historically taken many months to form. For instance, the market peak for the S&P 500 in 2000 took about eight months to complete. Basically, the market has drifted sideways for all of 2005, in what we believe is another topping formation.

Along the way, and as tops are formed, you tend to see a series of nonconfirmations or divergences among the major indexes. For instance, while some of the major indexes peaked in early August, such as the S&P 500, the Nasdaq, the Nasdaq 100, the Philadelphia Semiconductor Index and the Russell 2000, some other important indexes put in peaks many months ago. The Morgan Stanley Cyclical Index, the Philadelphia Bank Index and the S&P Consumer Discretionary Index all topped out in December, 2004. The Dow Jones Industrials and Dow Jones Transports reached their last peaks in March, 2005.

While it is possible that these indexes could reverse and put in new cyclical bull market peaks, the formations that they are tracing out for the most part are all potential head-and-shoulder reversal patterns. In our view, these nonconfirmations are a warning sign for investors, and should not be taken lightly.

Last week, the S&P 500 fell to multiple areas of support in the 1205 to 1210 area and bounced. There is trendline support, drawn off the June and August lows that comes in at 1207. Chart support, from the lows in August also lies in this zone. The 150-day exponential moving average lies at 1204, while trendline support off the declining peaks in August is at 1206.

With the drop last week, the S&P 500 is once again between the 50-day exponential moving average and the 200-day exponential moving average. In our opinion, the important level for the S&P 500 is right around 1200, or the lows from August. This is because a close below this level will complete a bearish, double top reversal formation, and suggest lower prices are in store. The width of the double top is about 45 points. Subtracting this from the potential breakdown point of 1200 gives us a potential measured moved down to the 1155 area.

The 1155 level is significant for two reasons. First, the April lows were in this area and represent a zone of chart support between 1137 and 1165. Second, a 50% retracement of the rally since August 2004 lies exactly at 1154.

The Nasdaq broke below its most recent closing low of 2120.77 from Aug. 26, closing at 2106.64 on Wednesday. During Thursday's session, the Nasdaq got as low as 2093.06 before reversing to the upside. Like the S&P 500, the index's reversal occurred near some key pieces of support. The 150-day exponential moving average comes in at 2094, while strong chart support lies at 2100. The 2100 level had been a major ceiling for the Nasdaq during much of 2005, and therefore, we believe, represents important intermediate-term support. Underneath the 2100 area, there is a shelf of support that runs down to the 2040 level. Both the 200-day simple and the 200-day exponential moving averages lie right at 2077.

The Nasdaq is the first major index to trace out a clear lower high and lower low, which is one of the first indications of a downtrend. The Nasdaq's 50-day exponential moving average has turned lower for the first time since the beginning of the year, another negative sign in our view.

The internal makeup of the market continues to weaken as the bull market gets older and this can be illustrated by looking at the number of stocks making new highs and by looking at accumulation/distribution models. The number of new highs on the Nasdaq as a percentage of the total issues traded on the index has steadily declined since the middle of 2003. This deterioration in the number of new highs has occurred during a period when the Nasdaq has made a series of higher highs over the last couple of years. We also see this pattern when looking at the 10-day ratio of up volume vs. down volume on both the Nasdaq and the NYSE.

One potential positive for the market, in our view, is the big increase in put/call ratios on the CBOE of late. On Thursday, Sept. 22, the daily CBOE put/call ratio hit 1.41, an extreme reading and the highest daily reading since Apr. 15. The P/C ratio exceeded 1.00 for three straight days this week, and pushed the 10-day P/C ratio to 1.04, the highest since April, and lifted the 30-day P/C ratio to 0.97, the highest since June, 2004. However, over recent history, extreme P/C ratios have preceded many market lows so there could be more downside despite the high readings.

One long-term observation about put/call ratios is that they tend to trend up or down over long periods of time, depending on whether the market is in a bull phase or bear phase. From the end of 1994 to the beginning of 2000, p/c ratios trended lower during the powerful bull market. From 2000 until the end of 2002, these ratios trended higher during the bear market. From October 2002 until January 2004, put/call ratios fell, which coincided with the biggest part of the cyclical bull market.

Lately though, despite the gradual increase in the market, p/c ratios have trended higher. What this means is anyone's guess, but it bears watching. Is the options market anticipating another bear market -- or is it being overly pessimistic about the prospects for the major indexes? Time will tell. We, of course, remain cautious over the near term and more than a bit worried about 2006.

Arbeter, a chartered market technician, is chief technical strategist for Standard & Poor's

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