Stocks Can Fall Further

By MICHAEL KAHN | MORE ARTICLES BY AUTHOR(S)

AFTER OPENING SIGNIFICANTLY lower Tuesday, the Standard & Poor's 500 stock index spent the rest of the day climbing back out of that hole. Followers of candlestick charting saw a very clear and very large pattern called a "hammer" and it is supposed to mark an interim bottom (see Chart 1).

Given weakness in other technical indicators, I am not so sure.

Hammers are formed by days that open and close near their high with an interim drop and recovery. In candlestick lore, the market is said to be "hammering out a bottom."

A similar event occurred in February as the market pulled out of its January slide but there was a difference. The index was above its key 200-day moving average at that time telling us that the bull market was intact (see Getting Technical, "What are the Moving Averages Saying?" May 24). Today, the index is below that average so I am very skeptical of this being an important upside reversal.

By some measures, Tuesday's market action seemed inevitable. European markets were down as much as 4% by the U.S. open and financial headlines were reporting, in very large typeface, how the Dow Jones Industrial Average was about to lose its grip on 10,000. We could sense the fear building.

On the charts, the market lost a lot of value in a very short time leaving it "oversold." By some measures, 90% of stocks traded domestically were in such an overextended decline and that is often a tip-off that an upside reaction was due. The market does not like it when indicators move to such extremes.

But is this a good buying opportunity? If you are a trader with a short-term bent, perhaps. If you are looking for a good place to jump back into the market for the long haul, this is not it.

There are several reasons. The first is that the stock market does not act exactly the same way each time it forms a specific pattern. While technical analysis is based on the premise that people act in similar ways under similar conditions, the word "similar" is critical. Background conditions are not similar.

Aside from the 200-day average, there is another factor working against the bulls today. Two widely followed market cycles are due to bottom towards the end of the year.

Cycles are merely tendencies for stock prices to ebb and flow with measurable regularity. Most investors are familiar with the seasonal cycle where stocks are strong in the winter and weak in the summer. A more familiar name for it is "sell in May and go away."

A nine-month, or 40-week, cycle is due to bottom towards the end of the year. Nine months is also equivalent to 200 days, so we can see the link to the key moving average mentioned above.

It is not a perfect predictor of stock market lows but it is a good indicator of the bias in the marketplace. The last cycle low was earlier this year so at the end of the January correction, the cycle, and its bias for the market, was just turning up. We cannot say the same today.

Another major cycle scheduled to bottom later this year is the four-year, or Presidential cycle. It has been a very good indicator for major bottoms in the market for decades, catching such bottoms as 2002 and 1974, both the end of vicious bear markets.

Combine the seasonal, nine-month and four-year cycles and we can make a compelling case for market weakness all summer long.

We can now see how the short-term signal given by Tuesday's hammer candle is fighting the tide. If the S&P 500 does continue higher, it faces stiff resistance in the 1130 area. This would represent a 50% recovery of losses since the April peak and it is in the vicinity of the close of May 6 - the day of the "flash crash."

Rather than look for bargains in the stock market now, it would seem that it might be better to use any rebound to lighten up.