A Slippery Slope for Stocks

Major indexes have broken key support levels, and S&P believes there will be additional damage

From Standard & Poor's Equity Research

The stock market broke some key short-term support levels last week, and we believe additional damage will be seen over the next month or so. A failed rally attempt and downside reversal on Thursday, Feb. 9, adds to our cautiousness. Bond yields held up near their recent highs while crude oil fell to its lowest level since early January.

The S&P 500 dropped sharply below its 50-day exponential moving average on Tuesday, rallied back to it on Wednesday, only to drop back below it on an intraday basis Friday and then finish right near it as the week ended. The 50-day exponential moving average acted as good support during the small pullbacks in December and January, and many times provides solid support during an intermediate-term advance. This is the first major break of the 50-day since Oct. 4 -- right before the market was cascading into its mid-October lows.

The S&P 500 also broke below immediate chart support from the closing low from Jan. 20 at 1261.49. With the failure to make new highs during the late-January rally, the market has now traced out a clear series of lower highs and lower lows for the first time since September. The weakness on Tuesday took the S&P 500 right down to its 80-day exponential moving average. That average currently sits at 1255, and like the 50-day, is often a key support for the market. Short-term trendline support also comes in at 1255.

The next piece of support lies at 1246 and we believe this is a very important level for the S&P 500. First of all, it represents the bottom from the end of 2005 as well as key resistance from back in August and September 2005. In addition, it is a key Fibonacci retracement of 38.2% of the rally from October to January.

We recently talked about a topping formation known as a broadening top or megaphone top for both the S&P 500 and the Nasdaq. With the most recent action, we can now see another topping formation being traced out called a diamond. A diamond top is formed after an advance and is made up of a higher high followed by a lower high. The bottom of the formation consists of a lower low and then a higher low. The diamond top can appear to be similar to a head-and-shoulders top.

The measuring implications of a diamond top are simple. Take the width of the formation and subtract it from the breakout point. A break of the 1256 level on a closing basis would signal a completion and breakdown from this bearish reversal pattern. With the width of the formation 49 points, this would give us a downside target of 1207. This target is very close to key longer-term support from a trendline drawn off the lows in 2004 and 2005. A drop to this area sometime in March would correspond with our 39-week and 78-week cycle lows due in that month.

If the S&P 500 does break down, there are some key pieces of technical support that lie between current prices and the 1207 area. The 150-day exponential moving average lies at 1239. A 50% retracement of the latest rally targets 1231 while a 61.8% retracement lies at 1217. The 200-day exponential moving average is at 1229 and the 200-day simple moving average comes in at 1224.

Daily momentum indicators have been negative for some time after moving to overbought conditions in November and December. We have seen some very short term oversold readings from some of these indicators but not to the extent witnessed after the last three pullbacks. Weekly momentum indicators turned bearish this week for the first time since the August/September period of 2005. Many times, a pullback or correction does not occur until both the daily and weekly momentum indicators are in agreement.

Two very important characteristics that often develop as an intermediate- or long-term top is forming are distribution by institutions and a large drop in share prices of the current leaders. Both of these characteristics have occurred over the last month. We have seen a fair amount of distribution lately as the market has sold off on increasing volume. This is a sign that institutions are moving to the sidelines and lightening up their equity exposure. Our accumulation/distribution models are negative for the first time since October.

In addition to signs of distribution, there has also been evidence of churning, which is another form of distribution. Churning is when the market does very little from the day before but volume is high. It is another sign that institutions are lightening up on equities.

The second piece to putting in a top is a severe break in many of the current leaders. We have seen some very large declines by many of the stocks that were the highfliers of the rally from October to January. It has been our experience that when the leaders start acting poorly, caution toward the market is the best action.

The 10-year Treasury yield finished the week right near its recent highs up near 4.6%. Yields are sitting up near there highest levels since mid-November. While we have been frustrated with our calls for a major breakout in yields, the 10-year is once again bumping up against key long-term chart support at 4.7%. The 10-year yield has moved up to the 4.7% to 4.9% area four times since August 2003 and then reversed with yields then dropping back towards the 4% area. For now, yields have been in an uptrend since June, 2005, putting in a series of higher highs and higher lows. Both daily and weekly momentum is positive, pointing to the potential for yields to continue higher.

Short rates continue their strong uptrend, indicating to us that the Federal Reserve is not done with its tightening cycle. The 3-month Treasury bill, 1-year Treasury bill, and 2-year Treasury note are all at their highest yields since early 2001. The yield curve is basically flat but the spread between the 10-year and the 2-year has inverted slightly. The 10-year/3-month spread is only 14 basis points.

Crude oil prices fell over 5% last week, finishing at $61.84 per barrel. Oil has retraced about 50% of the advance that occurred from November to January. A 61.8% retracement comes in just above the $60 level. Chart support sits in the $60 to $62 zone and we expect prices to hold in this area and then resume their long-term advance.

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