Market Outlook: Bearish Background to Bullish Storyline

Includes: DIA, QQQ, SPY
by: Sean Hannon

The last two weekly market commentaries have discussed how the underlying trend of the market is now bearish and all rallies should be used to sell stocks and reduce risks. With nearly every news outlet spouting the bullish storyline, these articles served as an outline of a disciplined investment strategy. Those who followed the outline have done well as the Dow Jones Industrial Average (Dow), S&P 500, and NASDAQ each declined over 5% since my initial warning.

With the Dow still stuck below the psychologically important 10,000 level and all three major U.S. markets trading beneath their 200-day moving averages (MA), the bearish backdrop is clear. Even if many are still looking for a rally, we should understand that the primary trend is lower. Instead of focusing on how high prices will rally, we should instead consider how much further prices can fall.

Declaring a downside target in a bear market is as fraught with risk as trying to guess a top in a bull market. Once price targets are set, they invariably are proved incorrect. However, it is important to determine guideposts that will indicate the strength of the current trend.

For this target, we would typically rely upon standard resistance and support levels. Unfortunately, the current environment does not lend itself to such practices. After the nearly 70% rally off the March 2009 lows, most charts are caught in a no-man's land. Having broken below key support, no visible bottom appears.

This could lead to one of two conclusions. The first would be that the move off the March 2009 low was a rally in an ongoing bear market. If t true, we should expect those lows to be retested before the bear finally rests.

Having never believed government intervention could staunch a bear market and create prosperity, I am intellectually attracted to this view. However, it is not a practical trading strategy. With all the efforts put forth by the Federal Reserve (Fed) and government officials, stocks falling toward a new low would unleash another round of enormous quantitative easing. The long-term ramifications of this would be unknown, but in the short-term prices would rally.

The second method of creating a downside price target would be to use Fibonacci levels. Following this approach, downside targets on the S&P 500 and Dow would be 1,015 and 9,460 respectively (4-5% below current levels).

As markets continue struggling, keep these price levels on your radar screen. I continue believing the trend is lower and an eventual relief rally is likely. Once the market approaches these lower price targets, reduce short positions and prepare for such a rally.