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In last week’s Market Update we commented that the Outside Down week was a bearish pattern that meant lower prices ahead, albeit our expectation was for a bit more of a rally (to the 1000 or 1100 range on the S&P 500) before lower prices would follow. Our Intermediate Trend target for the S&P 500 has been the 950-900 range since early May.

However, Wednesday’s weakness sets up an even more unusual pattern potential for the market in the very short term. Like any price pattern, the one I will illustrate below is not perfect. Nevertheless, the fast potential decline that can unfold warrants extreme caution. Thus, the message of today’s blog is to use extreme caution in the days ahead as downside momentum may accelerate.

The Pattern

Let’s start be examining past time frames when a similar price pattern unfolded. Our first chart is of the infamous year 1987. Many subscribers had commented to me previously how the rally into the April, 2010 high reminded them of 1987 in that the market seemed to shrug off common sense and caution, ignoring many fundamentals as it rallied. There is even more in common.

A multi-month consolidation from March through June of 1987 preceded the final rally which peaked in August, 1987. After a brief decline, the S&P 500 rallied in a Three Wave fashion (a simple Up-Down-Up). From the peak of the three wave rally the decline took six trading days to post a new intra-day low. The new intra-day low was followed by a one day rally and sharp decline into October, losing 34% in twelve trading days.

Ten years later, a similar pattern unfolded in the Hang Seng Index. The second chart is of the Hang Seng Index in 1997 (remember the Asian Contagion?). Here too a multi-month consolidation preceded the final high in August 1997. A brief decline was followed by a simple Three Wave rally. From the peak of the three wave rally the decline took six days to post a new closing low. It rallied for just two day, before declining sharply, losing 42% in fifteen trading days.

Click charts to enlarge:

S&P 500 Daily 1987

S&P 500 Daily 1987

Hang Seng Index 1997

Hang Seng Index Daily 1997

Dow Jones Industrial Average Daily 1929

Dow Jones Industrial Average Daily 1929

The last past example is of the Dow Jones Industrial Average in 1929. The pattern here, too, was a multi-month consolidation leading to a final rally high in August, 1929. A brief decline led to a Three Wave rally. From the peak of the Three Wave rally it took just six days for the index to post a new intra-day low. That was followed by a one day rally, and then sharply lower prices.

Now let’s look at how the current S&P 500 fits into the above examples. As illustrated below; a multi-month consolidation led to a final rally in April. After a brief decline, a simple Three Wave Bounce unfolded into the June 21st high. From that peak, it took only six days to post a new intra-day low, yesterday (Wednesday).

Click to enlarge: S&P 500 Daily 2010

S&P 500 Daily 2010

Of course, there are plenty of differences between the charts, not the least of which is seasonality. In each of the previous examples the bull market high was during the month of August with a decline in October or November. We could detail a list of other similarities and differences, but none of that would guarantee or improve the probability of the outcome. We don’t “know” what will follow in the days ahead. But, we do know that a familiar price pattern has been set. That pattern calls for a very brief one or two day rally and then sharply lower prices. I would even give the pattern enough leeway to suggest that a one to four day rally should be followed by sharply lower prices. I mentioned in last week’s Market Update that there are technical reasons that could push the price target just below 900. If the above bearish scenario unfolds, I would expect the broad market averages to extend a bit to the 864-890 range on the S&P 500.

If the market can pull together more of a rally than these charts suggest, I see the upside potential as being more sideways price action. In that case, the market would probably repeat the price action that unfolded between May 25 and June 21, then decline into the 900 -950 range. It is, of course, possible that the market continues lower without a one to four day rally. In that case,we would expect that short term support near 1023 may offer the next opportunity for a one to four day rally. Thus, our view of the best case scenario from current levels is more sideways price action before declining. The worst case scenario would be a sharp drop into or just below the price range we have forecasted since mid-May.

There are two other thoughts worth noting before we close out this Blog. First, our Short Term Demand Indicator has turned back to a Sell Signal. As our readers know, our Long Term Supply & Demand Indicators are on a Sell Signal and have remained negative since May 18th. Our Short Term Demand gave a sell signal on May 05 and a Buy signal on With Wednesday’s price action our Long Term, Intermediate Term and Short Term Indicators are aligned in a Sell Signal. Historically, the strongest downside momentum has followed when all three of these indicators are aligned as they are currently.

Second, there was significant technical damage done to several market leaders Wednesday including Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Dell (NASDAQ:DELL), Cisco (NASDAQ:CSCO), Amazon (NASDAQ:AMZN). These individual issues and others violated important support in a meaningful way. At this time, given both the indicator positions and Wednesday’s price action, the path of least resistance points to lower prices in the days ahead.

Disclaimer: The information contained in this publication was prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary, or statement of all data. Opinions may change without notice. This report is published for informational purposes only and is not to be construed as a solicitation or an offer or recommendation to buy or sell any financial security. Trading and investing involves risk and past performance may not be an indication of future performance. Claassen Research, LLC and its author accept no liability for any loss or damage resulting from the use or misuse of this report. No Quantitative formula, technical or fundamental system can guarantee profitable results. No reproduction allowed without permission from the author. All rights reserved. © 2010, Claassen Research, LLC.



Disclosure: Short SPX, Short QQQQ

Source: What Will Markets Do in the Near Term?