Stock Market Long-term Consolidation Formation Breaks Down

| August 4, 2011

The S&P 500 index plunged nearly 5% today, confirming the recent break below support at the lower boundary of the long-term consolidation formation that has been developing since February.

When a head and shoulders formation of this type experiences a confirmed breakdown, a relatively quick move lower usually occurs, and the mini-crash experienced by the stock market during the last nine sessions certainly qualifies as an expected response. Since July 25, the S&P 500 has lost an astonishing 10.8%. This is precisely the type of violent, abrupt decline that we have been expecting since early this year when we observed that the latest round of quantitative easing was likely fully priced into equities.

Whenever a market event of this magnitude occurs, it is instructive to review the big picture in order to place the development into proper perspective. The sharp decline during the first three sessions of August has moved the S&P 500 well below support at the lower boundary of the cyclical bull market from early 2009.

As always, only the close matters, so a confirmed breakdown on the monthly chart would only occur if the index ends August well below bull market uptrend support near 1,300. However, the magnitude of the move from the beginning of the month favors a confirmed breakdown at this point. Additionally, long-term technical indicators have experienced material deterioration and they are now neutral to slightly bearish overall, indicating that the cyclical bull market has lost all of its upward momentum as a result of the developing correction.

With respect to long-term cycle analysis, the current annual cycle from July 2010 has entered the fourth month of its corrective phase following the annual cycle high (ACH) in May.

Long-term cycle highs form in conjunction with an annual cycle translation change, so market behavior following the development of the next annual cycle low (ACL) will provide the next signal with respect to long-term direction. The three basic scenarios that we outlined in June remain the most viable. In the first bearish scenario, the ACL would form at current levels and stocks would move up to marginal new long-term highs before quickly reversing and moving below the ACL. This scenario would confirm a transition to left translation and signal the formation of a cyclical trend inflection point at the marginal new high in late 2011.

In the second bearish scenario, stocks would fail to approach the last ACH before quickly turning lower and moving well below the latest ACL. This scenario would also confirm a transition to left translation, but the cyclical trend inflection point would be at the ACH in May.

Finally, the only bullish scenario would see stocks move up to meaningful new highs heading into 2012 after the formation of the next ACL near current levels.

As always, these scenarios are approximations of the most likely possibilities as identified by our computer models and the S&P 500 is likely to deviate from all three of them. However, they provide a useful framework for characterizing market behavior during this critical time period. It is important to note that even if the bullish scenario does unfold, subsequent gains would almost certainly be limited. The cyclical bull market from March 2009 is now 29 months old and it will likely terminate by early 2012, if it has not already. Therefore, according to the three most viable scenarios, if the cyclical uptrend has not already ended in May, it will likely end either late this year or early next year. In any event, the outlook for stocks remains extremely poor from an investment perspective.

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Category: Commentary, Market Update


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