Stocks: The Bear's Final Act?

S&P thinks there may be a chance that the fifth and possibly final wave of the bear market is upon us

The major indexes look to be breaking down from a continuation pattern, and we think it is possible that the fifth and possibly final wave of the bear market is upon us. We believe this could send the S&P 500 down another 7% to 12% to the 1170 to 1237 range over the next three to four weeks.

The price structure of many indexes appears to be taking the shape of a 5-wave decline and that is very typical bear market action. Within the 5-waves, there are three waves down and two counter trend or corrective waves up. Wave 2 cannot retrace all of wave 1 while wave 4 cannot move above the bottom of wave 1, otherwise the wave counts are invalid. Many times, the fourth wave is a triangle formation, which we have been talking about over the last couple of weeks.

Interestingly, these waves can be very symmetrical in both size and time. The first wave down to the closing low on November 26 took 33 trading days and encompassed 158 points and represented a 10% decline. The second decline or third wave of the pattern lasted 28 trade days and took the S&P 500 down 205 points or 13.5%. So looking back, both down legs were fairly close in time and size. Wave 2 and wave 4, both corrective in nature, also look very similar. The major part of the rally in wave 2 took ten trading days while the rally in wave 4 took eight trade days. Wave 2 was 109 points while wave 4 was 85 points. Using intraday prices, wave 2 was 117 points and wave 4 was 126 points. Another similarity comes into view and that is that the wave 2 consolidation took about 24 trading days to play out before prices started to breakdown. Wave 4 is currently in its 22 day and prices appear to be breaking down about the same time they did in wave 2.

If we can assume that we have started wave 5, and considering that the first two down waves took about 30 trade days, that would suggest that this last wave down will end sometime around March 17. This would represent the initial low of the bear market and we would expect it to be tested in the April/May time period, which could represent the final low of the bear market. If wave 5 is similar in size to wave 1 and wave 3, we could arrive at a target range of 1190 to 1237 as a potential low for the bear market.

The range of 1190 to 1237 jibes pretty closely with what we outlined over the last couple of weeks when applying simpler technical methods of support in trying to identify a bottoming range for the S&P 500. Interestingly, there is a key focus of support in the 1237 zone as this level represented a pivot high and pivot low from back in 2005 and 2006. We always like to look for levels on the chart that have multiple pieces of support as we believe this makes them more valid in using them as a target. The next key Fibo retracement of 50% of the bull market would target the 1171 level.

More and more, the market sentiment indicators we monitor are positioning themselves for a key market low, in our view. Because we are dealing with a different type of market then we have become accustomed to in recent years, it is somewhat difficult to flatly say that market sentiment in general has swung far enough to the fear side to indicate that the worst is over. It is a subjective opinion, in our view, and one that many times only becomes clear after the fact. Be that as it may, there are certainly some intriguing developments along the sentiment front, and ones that may suggest we are getting relatively close in time and price to a bottom. This would correspond nicely to our primitive wave projections above.

The equity-only put/call (p/c) ratio, which is considered an example of the "dumb money", has moved nicely higher since the end of December, indicating to us that investors are getting increasingly worried about additional downside. The 30-day equity-only p/c has been above 0.72 since the middle of January, a fairly high level as compared with readings over the last five years. The OEX put/call ratio, considered a smart money gauge, has been falling since the middle of October, and is now in bullish territory. The 15-day OEX p/c ratio has fallen from 1.76 all the way to a recent reading of 0.91, indicating to us that the smart money is becoming bullish, and is positioning for a market bottom and subsequent rally. This recent low reading is near levels seen during corrective lows during the last couple of years and is also getting close to the levels seen at the bear market lows in 2002.

We have seen a cluster of sub-100 readings in the ISEE sentiment index, a sign of anxiety and fear among individual option investors. Since January 4, there have been 19 days where put option activity at the open was greater than call option activity. This is the greatest number of days under 100 for this index since the summer of 2006. During the summer and fall months, this index was frequently seeing readings up in the 150 to 190 area.

Both the Consensus and MarketVane polls have also shown large pickups in bearish sentiment, a positive from a contrarian view. Consensus has fallen to a recent low of only 25% bulls, the lowest since October 2004 and not far from the low reading of 21% in 2002. MarketVane has dropped from 74 in the spring 2007 all the way to a recent low of 40% bulls. This is the lowest percentage of bulls since May 2003. Unfortunately, this is nowhere near the bear market lows seen in 2002 when bullish sentiment dropped all the way to 17% bulls.

And therein lies the conundrum: Have the sentiment indicators overall dropped far enough or will it take another wave down to do the trick? Only time will tell.