The Stock Market Will Rally in December (^GSPC) and Then Crash -- Here's Why - TheStreet

The stock market is seasonally primed for a big Santa Claus rally. Don't let that fool you, however, because it's going to be followed by a huge market crash.

As the following monthly bar chart of the S&P 500I:GSPC shows, the pattern off the August low, labeled as wave (4), isn't quite complete. The minimal expectation for the completion of the pattern from Aug. 24 is shown in the first red oval, just above current price levels. The zone between 2135 and 2185 captures both a marginal new high above the May peak of 2134, as well as a stretch up to the upper two-standard-deviation band around 2185. The two-standard-deviation band contains 95% of normality, suggesting that bets that prices can exist outside the band for very long are suboptimal. As you can see, the S&P rarely moves outside these olive/gold colored bands and closes outside them even more rarely! Therefore, the lower of the two red ovals is not only the minimal expectation, but also the most probable.  

Click here to see the following chart in a new window

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If you look to the far left, you'll see the last time conditions appeared to be like the current environment. Back in 2007, prices were being contained by a green parallel channel, too, but one that was not as steep as the channel that has controlled prices ever since 2010. Then, after the lower red oval halted prices (July 2007), a steep selloff followed but was quickly reversed, then extended to the upper red oval (October 2007). While this occurred, the stochastics, in the lower pane, failed to confirm the higher high in price, and a bearish divergence sell signal was triggered. Coupled with the dual red oval tests of the upper two-standard-deviation band, and the test of the upper green channel line, these three signals combined to spark the dramatic decline that became the crash of 2008 (shown in the yellow box at the left of the graph). These same conditions occurred into the 2000 peak/reversal/crash as well, but are not shown here. If current conditions are like that, the initial red oval will be seen this week, followed by a couple of days or weeks of pullback, before a final thrust toward the upper red oval. That would imply a test of 2300 +/- 20. (Note that these conditions also would be similar to the 1929 crash, which we wrote about here.)

Notice that the same bearish divergence sell signal will be in place again this time, where the bold blue line in the stochastics pane is highlighting lower highs. Since both the 2000 and 2007 instances were followed by crashes in the S&P 500 of approximately 50%, the yellow box at the right of the graph is warning that a potentially catastrophic fall below 1200 is an outcome with historical precedence.  

Our objective decision support engine, therefore, is suggesting that a move higher into one of the red ovals, possibly both, is the path of least resistance, with 2160 (the center of the lower red oval) and 2300 (the center of the higher red oval) as the boundaries of the coming rise. The timing for the final peak is somewhat more nebulous. The intensity of the thrust from the low last Monday (Nov. 16) has been extraordinary, however. Hence, both ovals are within reach in the next one to six weeks!

All of this tells us that playing the finale of an aging bull market is not without risk. Thus, using 2015 as a line in the sand (a.k.a. sell stop) to protect your portfolio's value is strongly recommended if you're heavily long.  If you're flat, nimble buying can be done, as long as 2015 is used to exit and reverse to short exposure. If you're already short, the decision support engine affirms that adding into the 2135-2185 zone is the ideal action, given the overbought condition that will appear if prices stretch to those highs. 

So, prepare for a December to remember, as this one could join a short list of Decembers when Santa Claus provided dynamic price movements that weren't easily forgotten.

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This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.