Do You Believe the Gloom and Doom?

06/02/2011 10:38 am EST

Focus: STOCKS

Thomas Aspray

, Professional Trader & Analyst

Before simply giving in to the widespread selling and panic that have swept the markets this week, take a look at the current technical picture for help in making calm, well-educated decisions.

After weathering a torrent of worrisome economic and financial news over the past few weeks, stocks hit the tipping point on Wednesday, as the selling was heavy for most of the day. 

Today’s Wall Street Journal headline announced “Economic Outlook Darkens.” The combination of a weaker-than-expected ADP employment report, a sharp decline in manufacturing output, and a late-day downgrade of Greece’s debt combined to keep the selling pressure heavy.

One measure of how negative the action was is that only ten S&P 500 stocks were higher on the day. As I have been noting for the past week or so, the sentiment measures for the stock market are more consistent with a market bottom, not a top. 

This week’s sentiment reading from the American Association of Individual Investors (AAII) is likely to show a further decline in bullishness, as it will approach last summer’s lows of 20.7% bulls. Newsletter writers, while bullish overall, still have a high percentage who are looking for a correction.

Wednesday’s stock market decline clearly reversed the positives from Tuesday’s strong gains, but is it really the start of a more significant market correction?

I think it is impossible to gauge the true state of the economy or the direction of stock prices from monthly economic numbers that are always subject to revision. Therefore, the most objective approach is to look at the technical outlook to determine the market’s direction.

The overseas markets are sharply lower in early trading on Thursday, as those markets are now reacting to the US market troubles, but is a waterfall decline likely? Take a look at the technical evidence first; then decide.

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Chart Analysis: The Spyder Trust (SPY) closed just above last week’s low at $131.38 on Wednesday with more important support from the April lows at the $129.51 level.

  • A decisive break of the April lows could signal a decline to the March lows at $125.38
  • The cumulative NYSE Advance/Decline (A/D) line, which is the broadest measure of the market, made new highs on Tuesday. This means that the intermediate-term trend for the stock market is still positive
  • The first key level to watch is the late-May lows, while a break of the uptrend (line a) could signal a decline to the February-to-March highs
  • SPY has minor resistance now at $133.50 with major resistance at $135, which was where Tuesday’s rally stalled

The daily chart of the cash S&P 500 has trend line support (line b) now at 1302 with the April lows at 1294.98. If this level is broken, then the March lows and the rising 200-day moving average (MA) are now in the 1250 area.

  • The McClellan Oscillator, a short-term A/D indicator, closed above its downtrend, line c, on Tuesday before reversing sharply
  • It could get back to moderately oversold levels (-150 to -200) in a few days, and if it holds above the -150 level on the current decline, it could form a positive divergence
  • The S&P 500 needs to close back above the 1345 level to reverse the short-term negative trend

NEXT: What’s Ahead for Dow Industrials, Russell 2000?

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The SPDR Diamonds Trust (DIA), which tracks the Dow Industrials, was down by more than 2% on Wednesday, closing not far above the April lows and the uptrend (line b) in the $120 area. As of Wednesday’s close, DIA is down 4.6% from the early-May highs.

  • There is additional support in the $118 area with the 38.2% retracement support as calculated from the August 2010 lows at $116.04
  • The Dow Industrials’ A/D line made new highs in May, as the large-cap stocks were strong on the recent rally. The A/D line is still above the recent lows
  • The longer-term uptrend in the A/D line (line d) is well below the current levels with major support at last fall’s highs
  • If the A/D line has a similar correction to what occurred in February and March (highlighted in yellow), the correction may only last a week or so
  • DIA needs to move back above $125.55 to break the short-term downtrend

The iShares Russell 2000 Index Fund (IWM) was hit hard on Wednesday, falling by more than 3%. It had improved over the past few days, moving above its prior swing high. The uptrend, line e, was broken in late May.

  • IWM has next support at $80.76 with further support at $77-$78.50 and the March lows (line f)
  • The failure of the Russell 2000 A/D line to confirm the late-April highs (line g) warned of the current correction. Despite the recent rally, the A/D line still shows a pattern of lower highs
  • There is important support for the Russell 2000 A/D line at both the May and then the March lows
  • IWM needs to close above $85 to reverse the trend of lower highs and lower lows

What It Means: After Wednesday’s drop, some follow-through selling is clearly the most likely scenario, but the wild card for the short term is the monthly jobs report, due out this Friday.

For the S&P 500, a drop to the 1295-1302 level would not be surprising. This level is about 1.5% below Wednesday’s close. The number of stocks making new lows rose to just 39 on Wednesday, which is a positive sign.

Because both the weekly and daily NYSE A/D lines have confirmed the recent highs, an intermediate-term top—like what occurred in April 2010—does not appear to be in place.

Stocks could still grind lower over the next week or so, but then the surprises are likely to come on the upside. It would take a pattern of lower highs and lower lows in the weekly A/D line to change this view.

How to Profit: The key strategy for the current market has not changed much since early May when the small-cap stocks started to diverge from the rest of the market. Since then, I have recommended raising cash by taking partial profits on existing positions and limiting new buying to positions where the risk can be well controlled. Lastly, having stops in place is essential for all positions, as is resisting the urge to sell on panic. (See “Why Panic Sellers Could Be Sorry.”)

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