Stock Market Scenario Favours Continuing Decline

By: Andre_Gratian

SPX: Very Long-term trend - The very-long-term cycles are down and, if they make their lows when expected (after this bull market is over) there will be another steep and prolonged decline into late 2014. It is probable, however, that the steep correction of 2007-2009 will have curtailed the full downward pressure potential of the 120-yr cycle.

SPX: Intermediate trend - The Fed has extended the SPX intermediate uptrend, but for how long?

Analysis of the short-term trend is done on a daily basis with the help of hourly charts. It is an important adjunct to the analysis of daily and weekly charts which discusses the course of longer market trends.

Market Overview

A short-term correction has now been underway since the SPX touched 1474 about two weeks ago. In the process of forming a top, the index created a two-phase pattern of distribution, with the second phase giving us a projection down to 1430. That target was met last Wednesday after a sharp decline took the SPX down to 1430.53. As you will see on the chart, that level also corresponded to a secondary trend line, and the combination of support from the trend line and meeting the target brought a temporary end to the correction.

Since the low, SPX has retraced about .618 of the Tuesday/Wednesday decline and came back down to re-test the trend line (for the fourth time by Friday's close). Each bounce is becoming weaker, and it is becoming clear that the index intends to break that trend line and re-test its low of 1430. If that level does not hold, an extension of the decline down to 1424, and even 1414 is likely. That would be consistent with the count of the first phase of the top distribution pattern. If the consolidation that has taken place above 1430 is a re-distribution pattern -- which it appears to be -- the count that it gives us can be used as a confirmation of the top projection with targets to 1423 and 1418.

The scenario given above is the most likely, but it will have to be confirmed by the market action which could decide to be either more bullish or bearish. For instance, a count could be taken across the entire top formation which would render a projection down to 1396. The reason why the higher target makes more sense is because it coincides with the primary trend line from 1267, as well as a very strong support level provided by the August peak. However ... we'll let the market decide!

What we can say, is that if the lesser of the two projections turns out to be correct, there is a good chance that the market will resume its uptrend after the correction. We'll give reasons why this is very possible when we look at the charts.

Chart analysis

Anyone who has a modicum of technical analysis skill or interest has to appreciate the clarity conveyed by this daily chart of the S&P500.

To begin with, we could not find a better-defined bullish price channel with prices contained precisely between two parallel trend lines. The SPX found resistance exactly where it should have, at the top channel line but - and this is important - without any price deceleration. Why important? Because the majority of the time, under such circumstances, this is not the final high of the move. Chances are that it will subsequently be exceeded, as the price falls short of reaching the top of the channel. The implication is that we are currently only experiencing a correction in an uptrend, and not the beginning of a substantial decline.

That being said, is the correction already over and are we ready to resume the uptrend? For an answer, we turn to the indicators. The MACD histogram is negative and, on Friday, it made a lower low. Also, the stochastic RSI has not yet made a bullish cross. Both of these factors suggest that the correction is not over. We should note, however, that the SRSI has already gone to zero, and has bounced up from that extreme reading. It is now in a position to re-test that low (perhaps with positive divergence). When the two lines make a bullish cross, AND the blue line overcomes its former near-term high of -2.74, there is a good chance that the correction will be over and that SPX will be in a position to resume its uptrend. At that point, other factors should come into play, such as breaking the downtrend line and all indicators going positive.

If the correction is not yet over, how much farther is it likely to go? We have already mentioned that the most logical P&F projection from the top formation count -- as well as from the confirming count derived from the re-accumulation level at 1440 -- would be somewhere between 1414 and 1424. Let's see if there are technical reasons which substantiate these targets! We find that there is some impressive technical confirmation indeed! I have summarized it on the chart in the form of an ellipse which represents an area of strong support precisely in the projection area. It consist of a support level that goes back to the early April and mid-August tops (green horizontal line), the intermediate trend line which connects the 1267 and 1329 lows, and the 50-day MA. These three factors joining forces in the target area form a floor for prices which is virtually impenetrable and likely to produce an end to the correction.

Now let's turn to the McClellan oscillator (positioned under the SPX chart) to see if anything of value can be added to the above analysis. With last week's decline, the oscillator dropped to a moderately negative level before rebounding. Note that the level - roughly -50 -- sustained previous declining prices for the past year. The NYMO also found support on a parallel to the top (red) trend line drawn across the declining tops. Additional confirmation that we are ending the correction would come if the A/D decline did not continue retracing beyond the bottom red line. Here again, a signal that we are resuming the uptrend will come when the oscillator turns positive.

One final thought: if we are in an especially strong market, it is entirely possible that the pull-back will end with a re-test of 1430 and reverse from there.

After this detailed analysis, I don't think that it is necessary to show the hourly chart, but I will mention that the consolidation on the blue secondary trend line has taken the form of a H&S pattern with the trend line acting as its neck line. Should that pattern be valid, the H&S minimum projection is smack in the middle of the target area!

Cycles

Apparently, the 14-15wk high-to-high cycle is still alive and well since it did bring in a top in the estimated time frame.

Considering the above analysis, the cycle lows predicted for mid-October might come a little sooner, perhaps even next week. If so, we could then start the final thrust to slightly new highs before a real correction takes hold, lasting until the low of the 66-wk cycle in early January.

Breadth

The Summation Index (courtesy of StockCharts.com) has turned down in conjunction with the correction that started at SPX 1474, but it remains in an uptrend as long as it continues to make higher highs and higher lows.

In spite of its current uptrend, the index is still well below its February top while indices have exceeded their price levels for that date. Intermediate-term deceleration is beginning to assert itself, and it should be a red flag for intermediate-term investors.

Sentiment Indicators

With the pull-back in the market, the SentimenTrader (courtesy of same) has backed off its more bearish reading and may be giving the indices a little breathing room to reach their final destinations.

VIX

VIX continues to bump along the bottom level which is normally associated with a market top, but it has not been able to effectuate a credible reversal which would signal that a market top is in place. In order to do this, it would have to end its string of lower short-term tops and start to make higher ones. It would also have move outside of its trend line and above its 200-DMA. And if it were going to be a really important reversal, it would eventually have to move above 27.00.

That it may not be quite ready to do that is evidenced by the fact that XIV (reverse VIX) made a new high about a week after the SPX made its 1474 high. Normally, negative divergence occurs to signal a top, even if it is only a few hours before the price high.

XLF (Financial SPDR)

XLF gives perhaps an even better early warning signal than VIX. This is especially true over the long-term. In 2007, the warning of a bull market top came several months ahead of time.

Right now, XLF looks weaker than SPX, but this is misleading. Actually, it is pretty much in sync with it. QE3 caused XLF to shoot ahead of SPX for a short period of time, but it quickly fell back and is now trading pretty much in line with it. You can tell this from the similar price distance from the bottom of the channel. There is no warning, here, that an important reversal is imminent.

BONDS

After a spell of weakness, TLT has had a good re-bound, rising from the bottom of its channel to the top -- a move of 7 points in two quick weeks. It is beginning to show some inclination to make a short-term top, although it may not be done with attempting to break out of its downtrend channel. The indicators are both oversold and could quickly make moves back to their tops as the market corrects further. Inability on the part of TLT to move higher would be an indication that the market is not ready for a severe correction.

UUP (Dollar ETF) Daily Chart.

UUP has briefly broken through a support level in what has been one of its most severe pull-backs since it rose out of its base last September. Although it has managed to get back above the support line, the rally does not look that determined -- nothing like the one off the November low. This probably means that a longer period of consolidation will be needed and, if this is so, it will not have much of an influence on the SPX. It is also possible that the euro has a little uptrend left. The P&F chart gives FXE (127.62) a potential move to 132.

GLD (ETF for gold)

GLD met an intermediate projection at 185 about a year ago and has been correcting ever since. The decline found good support at 149 during June and July, in conjunction with the bottoming of a 25-wk cycle, and GLD built a base which, on the P&F chart, has enough of a count to take it back up to its former highs. However, this base is made up of two distinct phases and, by rising to 171, GLD has exhausted most of the energy stored in the first phase but could still make it to 179 if it can get above the strong resistance area formed by two former peaks.

The deciding factor could be the 25wk cycle which has been the primary motive force behind GLD's swings since 2008. It is now slightly past its peak and may not have enough lift remaining to take the index past the resistance level. If it does not, GLD will continue to build a distribution pattern at the current level which, when complete, will determine the extent of the pull-back into the next cycle low (due sometime in December).

OIL (USO)

The big picture on oil is instructive, showing that USO (and therefore oil) is not likely to go very far anytime soon, and has a potential bias for a move down to 28.00. The index could make it back to about 40 before rolling over, but if it starts down from its recent high, it would be accelerating its downtrend and creating a steeper downtrend line.

Summary

I have analyzed the daily SPX chart in great detail to show that the preferred scenario is a continued decline to about 1414/1424, followed by a rally to test the former high, or even to make a slightly higher high that would end the move from 1267.

The second best scenario would be to hold above 1430 before resuming the uptrend.

Lastly (10% probability), there could be a continued decline to about 1396 before finding support.

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