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The slowdown in the economy is finally affecting the markets with the Nasdaq 100 giving a clear bearish signal. A number of economic reports have been showing a growth deceleration, but the stock markets kept rising as the Federal Reserve eased money supply.

Let us look at the reports that have been showing a slowdown. The biggest is gross domestic product (GDP) growth, which fell from 4.1% in the last quarter of 2011 to 2% in the first quarter of 2012 and 1.3% in the second quarter of this year. This is surely a sharp deceleration.

The other big number is what the Bureau of Labor Statistics calls "U-6," which includes total unemployed plus all persons marginally attached to the labor force and total employed part-time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force. That number has stubbornly stayed above 14% for a very long time. These people are unable to robustly spend and invest, which has a negative effect on the stock markets and the economy.

The market is also looking at the looming fiscal cliff and the possibility of higher taxes, especially on dividends and capital gains. These have put dampeners on the stock market.

Reflecting the deteriorating economic situation, the Nasdaq 100 formed a bearish head-and-shoulders chart pattern. In fact, in 2007-08 the S&P 500 formed a head-and-shoulders pattern and the rest is history. Similarly, when the markets bottomed and rallied after March 2009, a bullish inverse head-and-shoulders pattern was formed.

Hence, when a major index forms a head-and-shoulders pattern or the inverse, it is time for investors to sit up a take notice. When the pattern is formed in the midst of a slowing economy and stubbornly high unemployment, it is something that must not be ignored.

The other two major indexes -- the S&P 500 and the Dow -- did not form a head and shoulders, but they did form other bearish patterns. However, the Nasdaq 100 is more important to spot a reversal of the bullish trend, as it has been the strongest of the three indexes. We will show you later in the article why the Nasdaq is the strongest, but for now let's look at the chart patterns.

Click to enlarge image.

Bearish patterns in the three indexes

We are looking at the QQQ, the ETF that tracks the Nasdaq 100, which is the top chart in the image and shown by the yellow line. You will notice the head and the left and right shoulders on the chart. Also notice that the neckline has been broken. The break of the neckline in the head and shoulders confirms the chart pattern and the uptrend reversal. Stockchart.com's Chart School states that a head-and-shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal.

To track the S&P 500 we are looking at the ETF SPY. Notice that the SPY, shown on the middle chart, has made a lower high and a lower low. In an uptrend, the market makes a continuing series of higher lows and higher highs. A higher low happens when a latest low in price is higher than the previous low, and a higher high happens when latest high in price is higher than the previous high. When that trend reverses, the market first makes a lower high and then a lower low as shown by the SPY chart.

Now lets move to the Dow; to track the index we are using DIA. Notice that DIA made a double top, which is bearish, and made a lower low. A lower low confirms the double-top formation.

The gathering clouds on a fundamental level -- which include slowing GDP growth, persistently high unemployment, the fiscal cliff, and potential tax increases -- combined with confirming bearish chart patterns should be a warning sign for bulls.

Finally, the reason we looked at the Nasdaq 100 to provide the reversal of the uptrend is because that is the strongest index. We call it the strongest as the index rose nearly 150% from its March 2009 bottom, while the S&P 500 rose about 95% and the Dow rallied about 92%. It is clear that the Nasdaq 100 was leading the markets up, and when the leader loses steam the laggards fall with it.

Trading Strategy

We'd wait for a rally in price to short. In case the QQQ reaches its downtrending neckline, we'd short with a stop above the neckline. If the neckline is broken, the next place to short would be near the right shoulder, with a stop above it.

For the SPY, the downtrend line is the first area to short with a stop above it. If the rally continues, the next level would be the last high in price.

Source: Nasdaq Confirms Bearish Pattern, Dow And S&P 500 Follow