Long-Term Charts Help Predict Early 2010 Market Direction

01/01/2010 12:01 am EST

Focus: STRATEGIES

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

As we approach the end of 2009, headlines are already rolling off the popular financial media presses, trumpeting how extraordinary the rally of the past ten months has been. "S&P 500 on pace to record largest annual gain since the 1930s," was one such headline we saw last night. Indeed, there's no denying the facts of this year's huge advance.

However, at a time when investors are in their bliss, it's important to keep the "big picture" in perspective. Although traders and investors often have short-term memories, do not forget the S&P 500 tumbled 38.5% in 2008, its biggest loss since a 38.6% plunge in 1937. The Dow Jones Industrial Average similarly nosedived 34% last year, its steepest drop since 1931. This means one of the largest annual declines in the history of the stock market (2008) was followed by one of the market's largest historical gains (2009). A shocking new paradigm? Not really. This is often the case during periods of high volatility, and the same thing happened in the 1930s. Simply put, the larger the drop, the greater the recovery; the greater the rally, the larger the subsequent correction.

Let's take a step away from the hype of this year's rally, and take an objective look at the long-term charts of the benchmark S&P 500 Index. Below are two weekly charts of the S&P 500. Fibonacci retracement lines are applied on the first chart, while the second chart marks the long-term downtrend line of the S&P 500, beginning with the October 2007 high (semi-log scaling):


Click to Enlarge


Click to Enlarge

As shown on the charts above, the S&P 500 is poised to enter 2010 at two pivotal resistance levels. First is the 50% Fibonacci retracement from its October 2007 high to March 2009 low. Time and time again, the 50% retracement level has proven to be a pivotal level for stocks, ETFs, and indexes, especially for longer-term trends. The second key area of resistance is the downtrend line that has been in place for more than two years. With the S&P bumping up against that trendline right now, one must still concede the dominant long-term trend is technically still "down."

Nevertheless, just because the S&P 500 is up against two major levels of resistance right now does not mean 2010 will be a losing year. Rather, the "big picture" merely gives astute traders and investors legitimate reasons to perhaps reduce position size and/or tighten stops on winning positions they've been holding.

Every year at this time, subscribers send e-mail asking us to share our predictions for the upcoming year. Since we believe in the mantra "trade what you see, not what you think," we're always hesitant to share such long-term thoughts. However, this year we'll satisfy the masses and give it a whirl anyway.

Because the sell-off of 2008 was so monstrous, and the rally of 2009 so powerful, it seems the market may be reaching some sort of equilibrium, at least in the mid- to long-term. Therefore, our best “prediction” (we really hate using that word) is that the dominant theme of 2010 will be sideways, range-bound trading that culminates in a slight gain or loss by this time next year. If the market plays out in this manner, it would be just fine with us. Since the basis of our style is identifying sectors and ETFs with relative strength or weakness to the broad market, our trading strategy works quite well in range-bound markets. This is confirmed by our historical performance record, which indicates our most profitable years were often those without a strong trend. As such, it wouldn't be so bad if our "prediction" happens to be right.

By Deron Wagner of Morpheus Trading Group

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