Stocks: To Test or Not to Test

Major indices seem ready to test November lows. Until then, it is better to stay on the sidelines

The recent trends in the financial markets remain in place, with the major indices still in downtrends on multiple time frames and setting up what appears to be a crucial price test of their bear market lows posted in November. In addition, and a potential bullish sign in our view, is the continued surge in long-dated Treasury yields. Not to be left out, the financial sector remains the ten-ton elephant sitting on top of the overall market, with little sign that the great pachyderm wants to get up.

As the major indices approach their bear market lows, many times we see investors jumping the gun in hopes that we will not see a full retest of those price lows. This can be seen by watching the market closely on an intraday basis. Thursday was a great example of this as the market bounced up and a down fairly violently, indicating some attempts to "buy" the potential bottom. However, when looking at the closing statistics, it ended up being another loser.

This game of cat and mouse can whipsaw the best of traders, and I’m sure many were scratching their heads after Thursday’s session. For the rest of us, it is better to stay on the sidelines, playing the probabilities and waiting for either the indices to get a bit closer to their November lows before committing any capital to this train wreck, or by waiting for some upside resistance levels to give way before taking a more aggressive stance towards stocks. Jumping the gun is great if you happen to catch the falling knife, but if your wrong and don’t use tight stops, you have a good chance of selling a losing position near the eventual lows, and could miss what will eventually be a springboard to the upside.

At this point, we don’t see much to suggest that the market lows won’t be tested in the near term, as almost every piece of support for the S&P 500 has given way like the Philadelphia Eagles defense last week. The S&P 500 has sliced right through potential chart support in the 850/860 area as well as in the 816/820 zone without much of a fight. This has happened despite our belief that the market is oversold, and we think, at least, is due for a bounce. In addition, minor bullish trendlines have given way with very little fight. The index has retraced over 61.8% of the rally from Nov. 20 to Jan. 6, and this also suggests a full retest is in the cards.

On the upside, the first main area of chart resistance lies in the 850 to 860 range, which acted as support multiple times in December as well as the end of October. The next key chart resistance is up at the recent high of 944. The 65-day exponential, which is declining, sits at 923, while a 23.6% retracement of the bear market lies at 944. Quite simply, there are a lot of resistance pieces sitting on top of the index.

For a successful major market low to be traced out, culminating in the death of the bear market, we can look to see what has happened many times in the past to guide us through the trenches. These conditions have presented them many times in the past, but be forewarned, no market bottom is exactly the same, as this would make our job way too easy. Many times, the major indices will trace out price bases that extend many months. So far, we believe the price base started at the panic lows in October so the potential bottom is less than four months. Considering the length of time of the bear market, and magnitude of the decline, we expect a fairly large base, that we see lasting at least eight to ten months before being completed.

During a major bottom, many times the price tests of a low occur on lighter selling pressure or lower volume. This indicates that selling is drying up, alleviating pressure on prices. We many times see extreme fear in many market sentiment indicators as investors move to a maximum level of fear, pessimism, despondency, and depression. We think that based on the market sentiment indicators we monitor, and the many consumer sentiment indicators that are released on a monthly basis, sentiment has gotten bearish enough for a major low to be traced out. This segment also includes major pessimism in the media with the proverbial doom and gloom on magazine covers and web sites.

Many times we witness extreme oversold conditions with respect to price (momentum) and market internals. As far as momentum is concerned, many major market bottoms have occurred after the relative strength index cycled into oversold territory, sometimes on an extreme basis. As an example, the 14-week RSI fell to 26 or below in 1970, 1974, 1987, 2002, and of course, in 2008. During the panic low in October, the 14-week RSI, based on the S&P 500, fell to 16, the most oversold since 1962. Sometimes, bullish weekly divergences develop during bases, and we saw one in November as prices hit a new low and the 14-week RSI put in a higher low.

At major bottoms, market internal data gets very lopsided, with decliners well outnumbering advancers, declining volume swamping advancing volume, and new 52-lows surge, while new 52-week highs disappear. This has already happened to a major degree, as we saw 52-week lows soar to 88% of issues traded on the NYSE in October. We also see bullish divergences with respect to internal data during a base. New lows contract as indices retest their lows, and volume is not as one-sided during these retests. This improvement in market internals is ongoing and illustrates that the charts of many individual stocks are healing the damage from their major declines.

And finally, and obviously, this list does not exhaust everything; we many times see a completion of a major bullish reversal formation. This has many times in the past taken the form of a double bottom, but also an inverse head-and-shoulder, or a triple bottom. The key here is that some pattern gets traced out over time, the formation gets completed, and the trend reverses. But, we’re not there yet!

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