Stocks: A Correction Is Looming

S&P says the inability of major indexes to break to the upside may signal the beginning of a reversal

Mark Arbeter, CMT, Chief Technical Strategist

Two weeks ago, it was the Nasdaq; last week, it was the S&P 500 and the DJIA. Now all three have incurred failed breakouts. Can the pullback/correction be far behind? Meanwhile, bond yields surged to 5-month highs while crude oil bounced sharply off the $50 per barrel level.

The S&P 500 broke out of a one-month consolidation on Wednesday, Jan. 24, rising to the highest level since September 28, 2000. However, on Thursday, the index put in a key reversal day, erasing all the gains and then some. A key reversal day is a one-day pattern where prices sharply reverse during a trend. In an uptrend, prices usually open at new highs and then close below the previous day's closing price. The wider the price range on the key reversal day and the heavier the volume, the greater the odds that a reversal is taking place.

With the 16.23-point loss on Thursday, Jan. 25, and the 1.76 billion shares traded, we had a very wide price range and heavy volume. The breakout failure by the S&P 500, which follows one by the Nasdaq, is another warning for investors that a defensive posture is appropriate, in our view.

Even with all the volatility of late, and the many technical warnings that we have seen, none of the major indexes have broken down from a price perspective. While we believe a price breakdown is coming, and our constant warnings have tended to be early at the tops, we would prefer to alert investors to the possibilities, as it is much easier to sell stocks when they are rising. Proclaiming that a correction is here by waiting for a price breakdown is gutless and forces investors to sell after a price top and into weakness, something much less pleasant than selling into strength.

We believe the key area of support for the S&P 500 is right around 1410. This represents the bottom of the recent one-month consolidation. With the loss on Friday, Jan. 26, the index had a minor break of trendline support off the August lows. This trendline, as well as the 20-day exponential moving average, comes in at 1424. The 30-day exponential average, which has done a good job providing support during pullbacks since August, lies at 1420. There is minor trendline support at 1418 and the 50-day simple average comes in just below this at 1413. The 65-day exponential average is at 1401, while both the 80-day simple average and the bottom of the 21-day price envelope with a vertical shift of 2% and -2%, both lie at 1395.

The next important price low, which was put in at the end of November, is at 1382. As far as potential support from key Fibonacci retracements, a 23.6% giveback of the rally comes in at 1389, while 38.2% and 50% retracements lie at 1357 and 1332, respectively. As you can see, there is a real concentration of support between 1380 and 1420.

The Nasdaq has been a bit weaker than the S&P 500 since topping out on Jan. 12 at 2502.82. The technology-heavy index fell slightly below its 50-day simple moving average on Thursday for only the second time since August. The recent action has been very choppy, starting with the failed breakout last week. The index then rallied right back to the breakout area of 2466 on Wednesday before being sharply rejected at that level on Thursday, tracing out a key reversal day.

We think the key zone on the downside for the Nasdaq is 2390 to 2400. This area represents the bottom of the recent trading range. Also, the 80-day exponential moving average sits at 2391 while a 23.6% retracement of the six-month rally is at 2389. A 38.2% giveback targets the 2319 level while a 50% retracement would equate to a drop to 2262 or about a 10% correction. Long-term moving averages reside near these important Fibonacci retracement levels, with the 150-day exponential average at 2336, the 200-day exponential average at 2314, and the 200-day simple average at 2269.

One technical indicator that has worked very well over the past couple of years at calling intermediate-term market bottoms as well as intermediate-term market tops is the ratio of Nasdaq weekly volume to NYSE volume. We use a 3-week average of this ratio for our buy and sell signals.

This indicator is unusual in that it combines an element of internal data (volume) and transforms it into an indicator that measures market sentiment. Historically, when Nasdaq volume rises vs. NYSE volume, it suggests that risk taking is rising, and that bullish market sentiment is overheating.

During the last three years, whenever Nasdaq volume has exceeded NYSE volume by at least 40%, on a 3-week basis, the overall market has pulled back or corrected. This occurred in January, 2004, January, 2005, April, 2006, and just recently in December, 2006, and January, 2007. Following the last three readings of over 140%, the S&P 500 has pulled back 8.2%, 7.2%, and 7.7%. Not unexpected, the declines on the Nasdaq have been larger with drops of 17.2%, 12.6%, and 14.8%. This indicator tends to give sell signals about one to two months prior to an intermediate-term top.

Readers should remember, however, that what worked in the past, may not work in the future.

Yields on the 10-year Treasury note broke out to the upside last week, and we think weighed on the stock market. Bond yields hit 4.91% on an intraday basis Friday and finished the week at 4.88%, the highest since August 15. Over the last couple of weeks, the 10-year has completed an inverse head-and-shoulders reversal pattern, took out support in the 4.80% to 4.85% area, and broke above the 50% retracement level which sat just above the 4.8% zone.

Momentum is overbought on a daily basis but has room to move higher on the weekly charts. We think yields will continue to move higher, and our next target range lies between 5% and 5.25%. Longer term, interest rates remain in an uptrend, bond prices in a downtrend or bear market, since the major yield low in June 2003.

Crude oil prices rose sharply last week, finding support at $50 per barrel. Prices soared $3.43 per barrel or 6.6%. After the most recent plunge to the $50 level, we think that prices will base or move sideways between $50 and $56.50 over the next couple of months. Often, after a large decline, a market will drift sideways for an extended period as it works on a base. Initial chart resistance comes from the prior breakdown point up near $56/barrel. A 23.6% retracement of the bear market since last July targets the $56.52 level.

Once these objectives are met, it is possible that crude will fall all the way back to the recent lows as prices test important support. Daily momentum has turned higher while it appears that weekly momentum is bottoming in oversold territory.

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