A Brief Respite, Then More Pain for Stocks

While major indexes could enjoy a short rebound, S&P thinks the market will head to new lows. Chinese equities could be in for more losses

Last week's market gyrations provided the opportunity for any number of snappy headlines and clever catchphrases: The China Syndrome, Emerging Markets Meltdown, The Return of Volatility, Deep VIXed, Crash and Carry, When China Sneezes U.S. Catches Cold. "What happens in China, doesn't stay in China." You get the idea.

On Feb. 27, the S&P 500 had its worst day since March 24, 2003, falling 3.47%. More incredibly, the S&P 500 had gone 45 months -- or 949 days -- without a one-day drop of at least 2%. In addition, the S&P 500's winning streak of eight consecutive monthly gains came to an end with the 2.2% decline in February.

Unfortunately, we have probably seen the end of the very hypnotic price changes we have become used to, and spoiled by, as we think volatility will be with us until the current correction plays itself out. Many times, long intervals without one-day declines of at least 2% are followed by 12-month periods of increased downside volatility.

This marked the first monthly loss for the S&P 500 since May, 2006, when the index fell 3.09%. With the S&P 500 turning 50 on March 4, 2007, the break of this long winning streak is no way to celebrate a milestone. By the way, the "500's" longest winning streak, going all the way back to 1970, is nine months, and that occurred from August, 1982 until April, 1983. There were three other eight-month streaks that occurred in 1980, late 1994 into 1995, and late 1995 into 1996.

If this is the beginning of a correction, the price action so far is not indicative of what is normally at the onset of a move lower. The action on Feb. 27, a large drop on huge volume, is more commonly seen either after a correction has gotten under way or towards the end of a decline. It is very rare to see a large price slide start so close to recent recovery highs or all-time highs. Therefore, we think many analysts, both fundamental and technical, are to some degree flying by the seat of their pants.

Fortunately, we do not think the rules of market analysis have been thrown out the window. It may just be that the textbooks need to be updated.

Over the very near term, we think the S&P 500 has provided us with enough evidence to suggest that a minor low is in. Including the Feb. 27 intraday low, the index has found nice support in the 1380 to 1400 area. There are some technical supports in that area that we think halted the decline, at least for the very near term. There is a major trendline that is drawn off the peaks since 2004 that sits right near 1400. This trendline used to be the top of a bullish channel, and therefore, was formerly, resistance. When the S&P 500 broke above the top of this channel, the top trendline then became potential support. In addition, the first key Fibonacci retracement [DEF FROM KARYN'S PIECE] of 23.6% of the 19.3% rally since June came in at 1404.

One other key piece of information that leads us to believe that a very short-term bottom is in was based on the price action on Mar. 1. The "500" traced out a fairly large hammer formation, that many times marks an important low. The market rebounded sharply from the lows that day, indicating that investors were covering their short positions as well as stepping back in to test the waters. These sharp intraday reversals that occur after a decline will many times lead to higher prices.

Now for the bad news. Once the short rebound of perhaps a week or two plays itself out, we think the market will head to new lows. Corrections need both price declines and an adequate space of time to wring out some of the excesses that have built up since the low last summer. The good news is that because of the relentless advance by the S&P 500 and many other indexes, and the absence of trading ranges or consolidations on the charts, the correction could be rather swift. There is very minimal chart support for the S&P 500 until we get down to the 1300 to 1326 area. The 1326 level was the last intermediate-term top for the index from last May.

So, we think there is potential for a quick decline into this first piece of decent chart support. Taking a look at other potential support levels from a Fibonacci retracement perspective, a 38.2% giveback comes in at 1369; a 50% retracement targets the 1342 level, while 61.8% is at 1314. Other possible supports come from the 200-day exponential moving average at 1365, the 200-day simple average at 1344, and the 65-week exponential average at 1335. In addition, extending trendline support, drawn off the lows over the past couple of years, out to the end of April, gives us longer-term trendline support just below the 1300 level.

Our biggest concern remains emerging markets. Exchange-traded funds that hold shares of companies from Mexico, Brazil, and of course China, have captivated investors' attention and attracted their funds. Even with the recent sharp losses, we see additional downside. Our most recent analysis back in early January [LINK TO CHINA CORRECTION] highlighted the iShares FTSE/Xinhua China 25 Index Fund (FXI). At the time, the FXI was just topping out after surging 76% since June and 24% in one month. It was a classic blowoff top with a parabolic move at the end. It was clear evidence of aggressive speculation, in our view, and an accident waiting to happen.

Since the peak on January 3, the FXI has cratered almost 18%. The problem we see technically is that because of an absence of chart support due to the parabolic rise, there is virtually an absence of support until we get down to the 80 to 85 zone, which is another 11% to 17% below current prices.

One area that we think has benefited from the instability of equities is the Treasury bond market. The yield on the benchmark 10-year Treasury note is at key chart and trendline resistance in the 4.4% to 4.5% range. A break below this range could open the door to a drop in yields to the 4% to 4.2%. A lot of this drop in yields will have to do with what the stock market does over the next month or so.

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