Get Ready For the S&P 500 to Break Below 1200

by: Greg Feirman

If you’ve been following the stock market this week, you might have come to the conclusion I’ve come to after many years of study: The stock market is a pain in the ass.  Put another way, the day to day moves frequently make no sense.  Thankfully, they are mostly noise and it’s the trends that show themselves over weeks, months and years that are the most important.

Consider this week (S&P 5-Day Chart):

  • MONDAY: Stocks surged at the open on the government bailout of Fannie Mae (FNM) and Freddie Mac (FRE).  Midday they gave back most of their gains before rallying strongly into the close. 
  • TUESDAY: Stocks gave back all their gains from Monday on news that Lehman’s talks about raising capital from Korean Development Bank [KDB] had broken down. 
  • THURSDAY: Stocks sold off powerfully at the open on analyst downgrades of Lehman (LEH) and general concerns about its viability.  Then they reversed course and rallied back to breakeven by midday before a furious late day rally put them strongly in positive territory.  The S&P 500 was as low as 1211 on Thursday morning and as high as 1250 towards the close. 

Like I said - it's a pain in the ass.

The S&P 500 closed at 1249 yesterday, which puts us pretty much right in the middle of the recent range marked by the 1200 intraday low on July 15th and intraday highs around 1300 from August 11 and September 2 (S&P 500 3-Month Chart). 

Where do we go from here?

Personally, I think the next big move will be down and will take us below 1200.  That’s because I think, to a great extent, the bounce off the July 15 lows has been exhausted. 

What’s driven the bounce since July 15 are the financials and retailers.  The S&P Financials (NYSEARCA:XLF) are up 25% and the S&P Consumer Discretionary stocks (NYSEARCA:XLY) 17% from July 15 to Thursday's close.  (Even with all the worries about Lehman Brothers over the last 3 days and the selloff in the investment banks, the overall financial sector is only down 1.8% Tue-Thu).  Check out Bespoke’s pretty chart that tells the story so well.  In fact, the S&P Homebuilders (NYSEARCA:XHB) are up 45% over the same period (see Bob Pisani, “Market Leaders: You Won’t Believe Them”, Trader Talk, Thursday September 11). 

My look at the charts tells me these sectors are overbought and their moves to the upside about over.  Take away the leaders of any rally and you kill it.

Can any sector replace them and power the market higher? 

One candidate would be the commodity stocks, including energy, which have been hammered during the course of this last rally.  The S&P Energy stocks (NYSEARCA:XLE), for example, are down 15.5% from July 15 through Thursday's close.  Other commodity related stocks and emerging markets whose economies are commodity dependent, like Brazil, have also been hit hard. 

These stocks are oversold at this point and seem poised to bounce (see The Market Speculator’s excellent posts on the coming commodities bounce: “Commodity Trades And Last Nights Game Plan from The Trade Report” and “The Only Way I Know To Trade Post-Boom Commodity Bust”).  However, the thesis powering these stocks higher for years has been destroyed.  Most now believe in a global slowdown that will hit international markets as hard as the U.SAny move in these stocks, then, is likely to be only a bounce and not the beginning of a new move higher.

Here’s how I see it playing out:

  • The commodities and energy stocks bounce over the next few days - but those bounces only represent new opportunities to get short.  They won’t provide any fuel to push the market higher.
  • The financials and retailers start to give back some of their phenomenal gains of the last couple months.  These two sectors make up 25% of the market cap of the S&P 500, and more of its volatility, and will lead the index down.

That’s why I think the market is heading lower in coming weeks, and 1200 on the S&P 500 will at least be tested, if not broken to the downside.

Disclosure: None