Stocks Are Approaching A Brick Wall

Includes: DIA, QQQ, SPY
by: ChartProphet

The majority of the world is either optimistic or unsure about the future of the global economy. But with so many hurdles in the way and warning signals that point to a slowing, if not collapsing, global economy, the prudent and rational investor would be extremely wise by protecting his or her portfolio if not pulling out of stocks completely.

Fake Rally/Dead Cat Bounce

After essentially crashing from late 2007 to early 2009 and losing nearly 60% of its value, the stock market (as represented by the S&P 500) bounced back and more than doubled from March 2009 to early May 2011. However, even though the “recovery” powerfully carried stocks back toward the 2007 all-time highs, the stock market failed to make new highs. The failure to make new highs is a warning sign that we have yet to truly recover, regardless of the relative improvements since the depths of the recession. Even worse, the tremendous upward thrust in the stock market could have been just an illusion of recovery right before the next – and worse – recession and stock market crash.

The 2-plus year “bull market” and “recovery” from the 2009 lows could be just a sharp bounce and counter-reaction to the deadly economic situation the world is actually in. The bad news takes time to fully sink in, and this fact has allowed markets to rise on hopes of a sustainable recovery. Instead, the “recovery” in stocks and economies may have been just a pause before reality sets in and markets resume their downtrend.

As we warned in March 2011, this fake rally in stocks and economies may have been a “fool’s rally” or “dead cat bounce” – a sharp counter-trend rally before the market falls back into recession. Even more, this “dead cat bounce” we have witnessed is very similar to the fake rally that took place following the stock market crash of 1929 – before the Great Depression entered its worst stages (What Can the Great Depression Teach Us About Our Great Recession?). In other words, unless we resume the uptrend in stocks and sustain new highs, the global economy may be doomed to follow in a similar path to the Great Depression.

Deadly Topping Pattern

Forming a large Head-and-Shoulders reversal pattern since the beginning of 2011, the S&P 500, Dow Jones Industrial Average and many other market sectors and stocks capitulated in August - signaling the beginning of a renewed downturn.

Breaking down through the “neckline” (drawn under the Head and Shoulders pattern), the stock market has likely resumed its downtrend and confirmed an upcoming recession. We warned readers to get out of stocks on August 5 (Has the 500-Point Drop Confirmed a Great Depression 2.0?).

Since the Head and Shoulders pattern is one of the best signs of a peak in stocks, long-term investors would be greedy and stupid (excuse my honesty) in staying invested. Yes, there is still a chance the market makes new highs; but why take such a huge risk after a 100-plus percent move from the 2009 lows, when bad news continues to emerge, and when stocks just underwent one of the sharpest drops ever in August? The wise decision would be to pull out of stocks until we get some more clarity.

To emphasize how risky it would be to buy stocks at this point, take a look at the following charts:

Click to enlarge charts

Source: Technical Analysis, Kirkpatrick and Dahlquist, page 333

The similarity between the “textbook” Head & Shoulders pattern and our actual, real-world situation is shockingly uncanny:

If, in fact, the S&P 500 has just formed and broken down from a Head and Shoulders top, an upcoming drop could be severe, and could usher in a very serious recession. To make matters worse, the tremendous bounce in October (which has been the best month for the Dow Jones in 10 years) may have tricked many investors to jump back into stocks right before the next plunge. Many investors who just read the headlines and see “Stock Market Posts Best Gains in 10 Years” have jumped back in without realizing that even with the best month in years the stock market is still down. If the Head and Shoulders plays out, this tremendous bounce in October has just been a “pullback” to the neckline of the pattern - right before resuming the downtrend. We expect stocks to fail at the maximum range between 1275-1300 on the S&P 500 and 12,250-12,500 on the Dow. If prices break through and sustain above, the Head and Shoulders may be nullified. But regardless, the risks of going long at these levels are TREMENDOUS.

Even if you don’t believe in technical analysis and chart patterns, here’s a reason why we still may be approaching a very strong barrier: the bottom of the Head and Shoulders pattern that we pointed out happens to coincide almost perfectly with the level at which the stock market began 2011. In other words, we are approaching the level where stocks began the year. Why is this such a big deal? Because as stocks approach that level, many investors and funds will begin to pull out of the market in order to “break even." Considering we are approaching this break-even level from below, it could act as very strong resistance. Prices may break above, but why take such a huge risk when we are right at that level and chances are greater that stocks will fail.

Click to enlarge

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

Additional disclosure: Chart Prophet Capital is watching these important levels and awaiting confirmation in order to short.

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