Warning Signs for Stock Market Grows

By: Michael Swanson | Sun, Dec 23, 2007
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Dear Investor,

This past weekend I wrote a special WSW members only report in which I looked for a dip in the early part of this week and then a Santa Claus rally. In this report I wrote:

"The S&P 500 currently has support at 1465, the 50% retracement level of the November low and December and then at 1451, which is the 2/3's retracement level. Although it is possible the S&P 500 bounces off of 1465, due to the steepness of last week's drop. I see the current drop in the S&P 500 continuing further with a new low coming off of the 1440-1450 area."

"I then see the S&P 500 rallying back up to the 1495-1520 area into the end of the year, which I now consider critical resistance as it coincides with the December high, the downtrend resistance line connecting the October and December highs, and the S&P 500's 150-day moving average."

On Tuesday the S&P 500 fell down to 1453 and bounced with momentum that carried over in Wednesday as the S&P 500 closed at 1453. I still believe that the broad market, and gold stocks too for that matter, will likely trade higher over the next week or so, but I am already seeing further warning signs that if the rally continues higher it will be simply a bounce in a larger intermediate-term downtrend.

For one thing the simple price action going into Tuesday's low hinted that a bounce was coming. The major market averages had become extremely oversold on an hourly time frame, while the HUI gold stock index had fallen all of the way down to its 370-375 support zone. However, sentiment indicators did not signal that a real bottom was in.

In fact they are trading as if this is just a bounce in a bear market. The VIX ratio, which measures the volatility premium that investors play for puts, has declined since the markets fell hard last week. This mean that despite the quick drop in the markets after the FOMC meeting of last week investors are not bidding up volatility premiums. The put/call ratio also remains very subdued. There is no sign of any fear or panic in the options market. In fact it is just the opposite.

Investors complacency has also grown according to the Investors Intelligence survey. Tuesday's reading showed an increase of bulls from 56.5% from 53.3% from the preceding week while the number of bears declined from 22.4% from 25.6%. In other words despite the market drop investment advisors became more bullish!

This is the type of sentiment action you see in bear markets.

What is more internal market indicators such as the advance/decline line and ratio of new highs to lows for the NYSE has already traded below its November low. This is noteworthy, because the market tops of October, July, and February were all preceded by similar breakdowns in these indicators.

Put it all together and I think the market can possibly go up a little more from here. Another week of positive action will likely bring a near 60% bullish reading in the Investors Intelligence survey, which would reach the level seen at the July top and almost at the October top, which was a three year high. If the market can rally another week or not though, one thing is clear: Plenty of danger signs are appearing that are warning that the market is on very shaky ground.

The problem as I see it though is the current position the market is in is very dangerous point. A rally that fails at or below the 1500 level for the S&P 500 would lead to a correction that would take the broad market below its August and November lows and lead to the type of panic near crash like conditions we saw in August. We will have to watch the price action over the next week to see if this is about to happen. The risks are to the downside.

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Michael Swanson

Author: Michael Swanson

Michael Swanson,

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