Editors' Pick: Originally published Feb. 16.
The stock market's path for the next month or two is likely to take its toll on both bulls and bears. This is because of how the market tends to "frack" its way through major peaks and troughs, as some indices peak earlier than others, while others tend to trough earlier than others. If you know which index is leading the others, the solution is simple. Once the leader shows its hand, take the appropriate action in the followers and wait for them to catch up, as the profits should be close behind, right? Maybe. Unless humans are involved. We tend to use coping mechanisms that limit our ability to see what the markets are showing us. That historically results in situations where the herd becomes bullish at major tops and bearish at major bottoms.
Let's look at the current environment and see whether we can use an objective tool to analyze what's going in the market while ignoring the noise from the media and the noise in our own heads. The decision support engine is that tool.
Following is the monthly bar chart of an index many investors don't even know exists: the Russell 3000. It's even broader than the Russell 2000 and contains 98% of all investable stocks.
Note that the stochastics are not oversold, a condition that is indicated when they enter the light-green zone at the bottom of the lower pane. They did hit the oversold area at the end of 2008 and the beginning of 2009. Because they're not oversold right now, any bounce in the near future should be only temporary and should be followed by selling. You will see that there was a bearish divergence sell signal in the pink oval that coincided with the June 2015 highs. This signal occurs when prices make higher highs while stochastics make lower highs, and it's highlighted by the bold blue lines. You'll see that the blue lines in the upper pane point up, while the ones in the lower pane point down. You can also see that there is currently no bullish divergence buy signal.
It's also worth noting that the current situation is similar to that of early 2008 just before the stock market collapsed. Notice the left side of the chart, where the pink oval shows where higher highs in prices coincided with lower highs in stochastics. That was followed by a five-wave decline into the yellow box (labeled red A), then a bounce into the smaller darker pink oval (labeled red B), then a decline back to the yellow box (labeled purple 1) and then a rise into the red oval (labeled purple 2). That brought the index from the October 2007 peak to the August 2008 lower-lower high, which was the last window investors could have used to exit stocks before the selling really picked up.
Now, move your eyes to the right, and you'll see the same pattern. After last summer's peak, the index moved down in five waves into the yellow box (red A), then bounced into a smaller darker ink oval (red B), then declined back into the yellow box (purple 1), and then rose into the red oval (purple 2).
We don't want to let emotions cloud our thinking at a critical moment like this, so we ask the decision support question, "If I had no money in the market right now, would buying or selling actions objectively indicated by the empirical evidence visible on the chart?" The decision support engine monitors many variables, and right now very few indicate that buying actions would be appropriate. There are many data points suggesting that selling actions are indicated.
The decision support engine tells us that we can't rule out one more new high for this index around 1350 +/-50. Thus, we have shown the alternate path with the blue arrow that points higher from current levels. Such a path will be triggered only if the Russell 3000 closes at more than 1250. Until then, the intermediate- to long-term path is lower.
We noted last Thursday, when stocks were plunging to their lowest prices since last August, that a temporary lift in stocks was due. We showed the Nasdaq 100's intraday chart to illustrate the probable path the stock market would take in coming days or weeks, with a target zone of 4350 +/-125. By Friday's close, the Nasdaq 100 had risen to 4020. As of Monday evening, index futures were following through with a large rise, hinting the Nasdaq 100 could test 4100 at Tuesday's open, pull back for a day or two and then reach toward 4280 +/-50 by the end of this week. That last zone is equivalent to about 1150 on the Russell 3000 index shown above.
The decision support engine's suggested objective course of action is to use the bounce targets of 1150 in the Russell 3000, 1025 in the Russell 2000, 1915 in the S&P 500, 4350 in the Nasdaq 100, and 16,600 in the Dow Jones Industrial Average to drastically reduce your long stock exposure and prepare for the coming market collapse.
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