3 Reasons The Bull May Turn Into A Bear

Includes: DIA, QQQ, SPY
by: Scott Gibson

Here are three reasons the bull market may turn into a bear:

Reason 1 - NASDAQ (NASDAQ:QQQ) Overhead Resistance
Reason 2 - S&P 500 (NYSEARCA:SPY) Overhead Resistance
Reason 3 - The type of ETFs passing screening models

This past week Joe Granville of the Granville Letter, a market timing newsletter, told Bloomberg television that he sees the market (as defined by the Dow Jones Industrial Average) dropping 1000 points in the first quarter of 2012 and then another 1000 points in each quarter thereafter, taking the Dow down 4000 points. Mr. Granville based this forecast upon his study of On Balance Volume. It was interesting to watch the Bloomberg interviewer's reaction when Mr. Granville made this prognostication. To say that he was skeptical of Mr. Granville's prediction would be an understatement.

So who is Joe Granville and what is his track record making these kinds of predictions? According to his newsletter's web site he was the 2005 and 2006 Gold Timer of the Year along with the number one timer of the year in 2011 according to Timer Digest. Timer Digest monitors more than 100 of the leading market timing models, ranking the top stock, bond, and gold timing according to the performance of their recommendations over various periods of time. So it's clear that Mr. Granville has been fairly successful in calling market turning points in the past.

After listening to the interview with Mr. Granville I asked myself whether there was anything other than On Balance Volume that may point to the fact that we are nearing a market top. Interestingly, several indicators support his view that we may be approaching a top. The first chart below shows the NASDAQ Composite Index going back to the beginning of 2006. The current value of the NASDAQ of 2812 is very close to the values that it has not been able to exceed over the past 6 years. On a weekly basis, the NASDAQ closed at 2810 on 11/2/2007, then at 2833 on 2/18/2011, then at 2873 on 4/29/2011 and finally at 2859 on 7/8/2011. I have placed arrows under these dates on the chart along with a horizontal magenta line showing the level of resistance on the chart.

(Click charts to expand)

Click to enlarge

Like the NASDAQ Composite, the S&P 500, which is currently trading at 1319, is also approaching an area that has acted as major overhead resistance for it in the past along with being a significant Fibonacci retracement level of 1361. The value 1361 represents a 76.4% retracement from the index weekly high of 1562 on 10/12/2007, through its low of 683 on 3/6/2009. As the chart below shows, the index has struggled to clear this value three different times in 2011, when it closed on a weekly basis at 1343 on 2/18/2011, 1363 on 4/29/2011, and finally at 1343 on 7/8/2011. This Fibonacci retracement level is also shown with a magenta horizontal line on the chart below.

Click to enlarge

Although it's clear that the major indexes are close to levels of overhead resistance, which they have struggled with in the past, there is not enough other compelling support for Mr. Granville's postulate that we are on the precipice of a major decline for risk-averse investors to bail out of the market just yet.

But based upon the overhead resistance and Mr. Granville's prediction it would be prudent to keep an eye on several other measures of market risk. One of the ways that we assess risk in the market is by screening a very large data base of Exchange Traded Funds to determine how many and what kinds of funds pass our risk adjusted screening criteria. At ETF Maximizer we go through this process for our subscribers on a daily basis, which gives us a clearer picture of the market's overall risk vs. reward and drives our monthly recommendations. Although the market has staged a nice rally over the past several weeks our software models are still favoring only municipal bond funds, high-yield corporate bond funds, investment grade corporate bond funds, consumer staples funds and other defensive investment ideas. This tells us that there is a lot of risk in the market, which generally supports Mr. Granville's contention and the charts of the indexes shown above.

It's clear from the charts that we need to be aware that another major market top may be forming and therefore it would be prudent to tighten stops, define hedges and keep abreast of the market's action over the coming weeks in order to exit to the safety of cash if the market does start to fall apart.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.