Why Friday's Sell-Off Will Take The S&P 500 Below 1400

Includes: SPY
by: E.W. Barnaba

I view the daily fluctuations of the market as a constant competition between two opposing teams: the Bulls and the Bears. The investors who "play" on these teams often don't care about the never-ending contest between the two forces, but the approach that they take towards the market on any given day will determine which team they're on - whether they realize it or not.

Investors who are optimistic about market conditions - those who feel that prices will go up in the future and that now is a good time to BUY - will find themselves drafted by the Bulls. Conversely, investors who are pessimistic about the future - who think that prices will go down in the future and look for a good opportunity to SELL - will end up playing for the Bears.

The direction that the price of any given stock will take - and by extension the broader indices that track the health of the overall market - is determined wholly by the two moves, BUY and SELL, that players in the game can make. If more people BUY a security than SELL, its price will rise as each buyer pays just a little bit more for it than the last. The same is also true of the opposite, and in extreme circumstances - such as Black Monday or the 2008-2009 crash - the unwillingness or inability of a large number of players to BUY can cause prices to drop sharply in a relatively short period of time as the Bears take over and dominate the game.

So how does all of this apply to Friday's mid-day sell off, and why will it take the S&P below 1400? Simply put, my thesis is that the Bears have taken over the current market; a majority of investors are viewing price swings to the upside as opportunities to SELL at more advantageous prices, stopping the Bulls and their nascent rallies in their tracks and sending the market lower in the process.
Source: Google Finance

The S&P 500's breakdown below 1435 on October 23rd and its subsequent inability to hold onto any gains has swung the balance of the contest over to the Bears as a majority of investors have lost confidence in the market - at least for the short-term - as revenues continue to come in below last year's levels and companies continue to lower their guidance for Q4. The S&P opened up 6 points at 1419 on October 24th compared to its previous day's close at 1413, a sign that many took as the end of a short-term correction and the start of a rally to new 52-week highs. However, by the end of the day the index had sold-off down to 1408. The same pattern repeated the next day as the S&P opened at 1420 on October 25th, yet closed down at 1412. On both days, the massive influx of buying during the pre-market was soon outweighed by a large amount of players using price spikes to sell their holdings at higher prices than they could have the day before. For the next two trading days, any time the Bulls took the S&P above 1415 the Bears would move in and take it back down.
Source: Google Finance

This pattern finally broke on Thursday, when the index opened at 1417 and rallied a further 10 points to close at 1427. Which finally brings us to Friday's session.
Source: Google Finance

Spurred by a better than expected jobs number, the Bulls made the first move of the day and opened at 1432. Admittedly, I thought that this was confirmation that the market had bottomed and that the Bulls had come out on top. However, the Bears countered by selling the S&P down to 1424 almost within the hour. The index hovered there until 1:50, when three massive rounds of selling throughout the rest of the trading day led us to a close at 1414, completely erasing the gains of the previous day, and taking us again below the 1415 resistance point of the previous week.

Friday's action demonstrates proof of my thesis - if there were more Bulls operating Friday than Bears, they would have used the dip to 1424 as an opportunity to buy on a slight pull-back from the day's open and lead the S&P to a close back near the 1435 resistance point. Their failure to do so shows that the Bears are currently dominating the floor, and their virtually unopposed waves of selling at the end of the day shows that the number of Bulls has dwindled to insignificant levels.

I believe that the market will continue to sell off on Monday, taking the S&P within striking distance of the 1400 resistance level by the day's close. Friday's dramatic price drop will have swung enough neutral investors over the Bears that prices will continue to fall as any rallies are stopped in their tracks by waves of selling. Tuesday's action will finally bring us below 1400, and into new territory.

I think the most likely outcome is that the correction will stop near the 200 day moving average of 1380. I think we're still within a Bull Market, but that further correction is needed before the Bulls can challenge the year's highs. However, should we continue to trade below 1380, I think there is a possibility that we may have entered a Bear market, as Q3 disappointments and Q4 fears compound to take the S&P below 1300. In this scenario, enough investors will have become convinced that the year's gains were baseless and inspired by the fervor surrounding QE3 rather than solid fundamentals and earnings that they will continue to play for the Bears until those gains are all but erased.
Source: Yahoo Finance

Looking at the chart above, you can see that the 10 day moving average is already in a Bearish direction, and that Thursday's mini-rally failed to break through its resistance point. The 50 day average has leveled out at 1435, and is only a day or two from tilting downward should trade continue below that point. The 100 and 200 day averages are still in control of the Bulls at 1400 and 1380 respectively, hence my belief in the Bull Market. But they're losing momentum, and should the S&P fall below their levels long enough to reverse their trends, I see no other conclusion than that the Bears have come out of hibernation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.