For Stocks, Easiest Path Might Be Downward

The recent selloff in the major stock averages has some investors wondering where it will all end.

The Nasdaq has fallen almost 6% since June 30, and the Dow and S&P 500 are down nearly 3% over the past two weeks, as a host of technology companies have issued profit warnings, and expectations for economic growth have been ratcheted down.

Many technical analysts say they expect major stock proxies to fall to the levels seen in May, suggesting that the S&P, Nasdaq and Dow could drop another 3.4%, 3.7% and 4.0%, respectively, from current levels. Some chart-watchers say an even bigger decline could be in the works, because they believe the trend of lower highs and lower lows so far this year will probably continue.

Since the start of 2004, the major averages have made several attempts to rally before breaking down. Each rally attempt has failed to recoup the losses incurred in the prior selloff, and each decline has resulted in a new low.

For example, the S&P 500 hit an intraday high of 1163 in early March before falling to 1087 later in the month. The next peak in early April left the index sitting at just 1151, and the subsequent decline pushed the S&P down to 1076 in May. By late June, the S&P peaked out at 1146, and after a recent selloff it is now sitting at 1114.

Paul Nolte, director of investments at Hinsdale Associates, said that if the May lows are broken, as he expects they will be, the S&P 500 could fall to roughly 1000, while the Nasdaq could slide all the way down to 1600. The Nasdaq's intraday low in May was 1865, while the intraday low for the Dow was 9822.

"We have a fair amount in cash and some money in mutual funds that short the market, and we're contemplating increasing that exposure," he said.

Nolte said he is troubled by the fact that volume has been heavy on declining days and light on days when the market has risen. But he is also concerned about fundamental issues such as rising interest rates and bubble-era valuations on some stocks. ADC Telecommunications ( ADCT) trades at 126 times this year's earnings, while Yahoo! ( YHOO) sports a P/E of almost 99 and eBay ( EBAY) is trading at 72 times earnings.

"Those tools are very poor at predicting when the market will turn, but they're at least decent in telling you how risky things are today," he said. "Things today are risky."

With expectations so high, any disappointing earnings or economic data could give investors a reason to sell, analysts say. Even if stocks don't break through their May lows, there is a growing consensus that the market will probably test those levels.

"The market appears to be vulnerable to additional weakness, now or after any short-term bounce," said Merrill Lynch technical analyst Richard McCabe in a research note. "There ... appears to be a need for further improvement in many short-term sentiment indicators."

Despite recent weakness, sentiment has remained quite optimistic. A poll by Investors' Intelligence showed that bullish sentiment rose to 56.3% in the week ended July 6, from 56.1%. And while the level of bearishness also rose, it still stands at just 17.7%.

"Sentiment of individual investors and professionals is excessively bullish at this time," said Bert Dohmen, president and founder of Dohmen Capital Research Institute. "That always suggests that most of the money is already in the market. Therefore there is nothing to drive stocks higher, but plenty to drive them lower."

The Chicago Board Options Exchange's volatility index, or VIX, seems to confirm that traders have been complacent about the recent selloff. The VIX index, which is considered by many analysts to be a measure of fear in the marketplace, was last sitting at 14.96.

"The VIX index ... would give a stronger indication of a market bottom if it were to rise further to at least the 21-to-23 range as it did in August-September of last year and March of this year," McCabe said.

The VIX rose above 20 in May. McCabe thinks the major averages will hold at or above their May lows, but he noted that if the Nasdaq falls "decisively below" 1876 -- its closing low on May 17 -- he would reassess whether the advance from the October 2002 nadir has "crested."

"At some point," he wrote, "when the post-2002 recovery is over, history suggests that the index will enter a trading range pattern which, based on historical precedents ('nifty fifty' growth stocks, gold and the Japanese stock market), could last for many years."

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