If history repeats itself, like it has done the only other two times in the past 102 years (since the Federal Reserve was established on December 23th, 1913) that this condition was present, the next few years will be very challenging for those with stock exposure. The condition being referred to is raising interest rates as the economy was slowing. The first of these two previous mistakes is blamed for the Great Depression of the 1930's, and the second came in late 1965. Within two months of this second mistake, stocks peaked in 1966, then fell 26% by the end of that year, and 37% by 1970.
Earlier this month, our decision support engine (DSE) warned that time was running out on the QE-stimulated rise from 2009's crash low. And, if the pattern analysis was accurate, a rare "megaphone" (or "jaws of death") formation was only weeks from termination. Since then, the situation has moved to a major decision point -- a fork in the road. However, though the paths differ for the next few weeks, they likely both end at the same destination: Dow 11,000, with more bearish potential thereafter. This chart below, of the Dow's quarterly bars, shows the perilous position that the Dow has arrived at (click the link to zoom in for the detailed view).
As the pink oval at the May all-time high may represent, or the red oval will represent at this month's lower high (or early January's slightly higher high will represent), the blue arrows from these extremes are both pointing to a multi-year decline that initially targets the 11,500 +/- 1000 zone, then a bounce, then another sharp crashing period that points toward the 2009 lows. As the lower jaw line of the Jaws of Death pattern illustrates, there is potential for the Dow to break the 2009 lows, and test 3500 +/-1500.
Returning to the current environment, the rising pattern still has the ability to push into the January 8 +/-3 days timing window. Last week, our DSE's algos refined the upside potential in great detail, not only in time but also in price. While the selling into Friday's expiration is straining the bull's conviction, it'll take a close below the August lows to eliminate the potential for one more new high; at least in the Dow, S&P, and Nasdaq 100. The Russell 2000 is very unlikely to join these three indices.
Among the reasons is that the past two major peaks in the last fifteen years (2000 and 2007) resulted in 5-to-11 quarters of declining prices after bearish divergence sell signals were triggered. These are illustrated by the higher highs in price vs. lower highs in stochastics, which the bold blue lines highlight in the upper and lower panes of the chart. The current signal is just two quarters in duration. Another reason is that both of the prior two sell signals brought the stochastics below the 20% level, and the current stochastics level is just breaking 80%. Therefore, there is still a lot of enthusiasm that needs to be worked off (ie. much more time, much lower stochastics, and much lower stock prices).
However, the underlying technical condition of the market, in the shortest term (days to weeks) hints that the selling into late last week was expiration related. Apparently, there were $1 trillion of index puts that were tied to the S&P level surrounding 2000. The evidence supporting at least a multi-day bounce, if not a generally higher trend into January 8 +/-3 days, is seen in the McClellan Oscillator that made its low last Monday near -300, rose to test the neutral "zero" line Wednesday, then only fell to -105 at Friday's close; a much less oversold extreme. In addition, the advance/decline ratio which closed at 7:1 negative last Monday, only closed Friday at 2:1 negative; a much less oversold extreme. The VIX Volatility Index, which peaked last Monday near 27, closed Friday just below 21, a much less negative extreme. Additionally, surveys of trader sentiment are showing rare extremes in short term bearishness, as only 5% of respondents consider themselves bullish.
This short-term condition hints of an oversold bounce that is due to begin from near the start of today's session. However, that doesn't preclude lower prices from arriving before the bounce begins, nor does it guarantee this is the place to begin buying.
When we ask the decision support engine "if I had no money in the market, are buying actions or selling actions indicated here/now?", the answer is an emphatic don't sell here, now. Even if prices continue to decline, selling at already oversold technical conditions is rarely correlated with a winning outcome. It's better go let a bounce occur, and sell into it, or await the end to the move that should take prices of the big three indices to new all-time highs into early January. If and only if prices break their August lows should all long exposure be exited immediately, and short exposure be adopted immediately. Otherwise, DSE suggests letting the oversold extremes now evident after last week's rout dissipate. There will be plenty of oversold bounces between here and the green boxes in the chart above to get aggressively short. This moment in time is not probability-ranked as one of them.
For more of this kind of analysis, try our many DSE-based services with a free week of full-access to our highest level membership. Special pricing is available for TheStreet.com readers who subscribe AFTER a no-obligation, complimentary trial week.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.