For the second time this year the market has broken the neckline of a classical “head and shoulders” pattern. For you non-technical investors this is simply a pattern of price movement that has been indicative of market topping patterns in the past. In fact, outside of the two times this year, the last time we witnessed a clearly defined “head and shoulders” pattern was at the peak of the market in 2008 just before the major crisis hit.
Back in April we first began to recommend overweighting cash and fixed income relative to equities due to the fact that the Quantitative Easing program by the Fed was coming to an end and the lack of stimulus was going to act like a vacuum on the markets. This was a highly unpopular position at the time, especially with the media, but has saved us lots of grief over the summer.
After the initial break of the “neckline” in early August during the midst of the “debt ceiling debacle” the market plunged to 1120 on the S&P 500 index. The market then remained range bound between the lows of 1120 and highs 1220-1230. After the initial plunge we began to repeatedly make calls in our weekly newsletter to sell into rallies due to the overriding weakness in the domestic and international economies. Furthermore, when trends are negative in the market the primary trading rule becomes “selling rallies” rather than “buying dips”. Each attempt at a rally in the markets failed at critical levels of resistance but repeatedly found support at 1120…until today.
The break of the “neckline” today leaves the market in a very tenuous position flirting with the August intraday lows of 1103 on the index. In our opinion this level most likely will not hold and we could well see the markets decline to the next major psychological level of 1000 on the index. This will be consistent with both the retracement of the initial selloff and the break of “neckline” support which should lead to a decline of the same proportion as the original decline. This will also be consistent with traditional bear market declines of 30% from peak to trough.
With the markets now negative for 5 months in a row a sharp decline to flush out investors could well set a short term bottom in the market. However, as we showed in our post on Friday, after 5 or 6 months (depending on how October ends) the markets have always rallied for 3 to 6 months before declining to new lows before finding THE longer term investment opportunity.
The point here is that many investors are now trapped in the market and are hoping for a rally so they can get out. This is why the next rally that we likely see will be into the the end of the year. This will most likely be a “suckers rally” as it will suck investors in as the media bleets about the end of the bear market. Unfortunately, that will be the set up for the decline to the longer lasting bottom. This was very much the same pattern that we saw play out at the end of 2008 as the rally abruptly ended and the markets declined 22% from January to the final low on March 9th.
Caution is highly advised. Having a hefty hoard of cash will provide the ability to take advantage of the next buying opportunity whether it comes sometime this month or next year. There are many threads of this finely woven economic fabric that are now unravelling. As such it will pay not only to be patient but “fashionably late” to the next buying opportunity to make sure it isn’t a “suckers rally”.