Stocks Approaching Major Long-Term Resistance. Is a Reversal Imminent?

Includes: SPY, UDN
by: Graham Summers

Having rallied virtually non-stop since the beginning of September, stocks are now about to come up against MAJOR long-term resistance in the form of the 200-week moving average.

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As you can see, the S&P 500’s break below the 200-week moving average was what heralded the beginning of SERIOUS trouble for stocks in 2008. And since the Crash, it has acted as THE line of resistance for stocks’ rally. Indeed, it stopped stocks dead in their tracks at the April 2010 top.

Below is a close-up of the market’s action for the April top through today. As you can see, we’re about 12 points off from the 200-week moving average. Bear in mind, we don’t necessarily need to touch the line (we didn’t in April), so as of right now stocks are in danger of a severe reversal at any time.

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This ties in with my view that stocks have been forming a bearish rising wedge: a classic topping pattern. As pointed out in last week’s forecast, this was precisely the same pattern we saw in the July rally. That pattern, when broken, saw stocks falling nearly to their base. If this current pattern breaks in a similar fashion, we should see the S&P 500 back at 1,060 relatively quickly. I’ve included both patterns in the below chart:

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Aside from this, we also have resistance at 1,190, which adds to the potential for a reversal here. Does, this doesn’t mean we’re looking at a full-scale collapse right away? Not necessarily. Because of its “stair-step” fashion, this rally has built up a series of support lines which all offer the potential for a bounce. So once the bearish rising wedge breaks, the collapse doesn’t have to be sudden.

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We’re also getting signs that stocks are prime for a reversal from the US dollar. As stated last week, the S&P 500 is now trading in near perfect inverse correlation to the US dollar. With that in mind, we need to consider that the US dollar may in fact be putting in a bottom here.

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As you can see, the US dollar looks to have just bounced off of its multi-year trend line. The trillion dollar question is: is this a dead cat bounce… or the start of something more? To some degree, it doesn’t matter as the anti-dollar trade is so lopsided that even a small pop in price could induce a serious short-covering spree (traders have placed a record number of bearish dollar bets).

One easy means of determining whether this is the start of something bigger is the 20-day exponential moving average. As the below chart shows, this line has served as a decent proxy for collapses/ significant rallies. If the US dollar breaks above this line, we’re likely going to 81 before it turns down again.

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In the context of all of this (stocks coming up against their 200-week moving average, the rising bearish wedge pattern, a US dollar reversal), the downside risk for stocks here is VERY, VERY high (as in April 2010 high).

Remember, ALL of these latest rally’s gains have been based on rumor and insinuation that the Federal Reserve is about to announce a MASSIVE ($1 trillion or so) QE 2 program at its November 3 meeting. If the Fed DOESN’T announce such a program or disappoints Wall Street by announcing a smaller program, stocks could absolutely COLLAPSE.

However, until the Fed’s November 3 meeting, the likelihood of a full-scale collapse isn’t high. Indeed, the Fed has POMOs (its ongoing QE lite program) on Tuesday and Thursday this week, so we could easily see intraday ramp jobs on those days.