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Make or Break Time for the Stock Market

|Includes: DIA, QQQ, SPDR S&P 500 Trust ETF (SPY)

We are at an important juncture with regard to both the economic recovery and the long-term trend in the stock market. The Census Bureau recently reported that manufacturers' and trade inventories were up slightly in May from the prior month, and the massive adjustment that produced the majority of the reported GDP growth in the last two quarters has very likely run its course as shown on the following graph from Calculated Risk.

Reported GDP growth was 5.9% in the fourth quarter of 2009 and 2.7% in the first quarter of 2010. If you remove the effects of these inventory adjustments, real growth was only 2.1% in the fourth quarter and 0.9% last quarter. That is certainly not the growth trajectory of a strong economic recovery, and now that the stimuli-driven bounce is effectively over, the markets are wrestling with the question of sustainability. Can the economy continue to recover and grow on its own, or are we heading back into recession?

Let's take a step back and review the big picture in terms of long-term trends in order to better understand the current message of the stock market. The secular bear market in stocks is now ten years old, and indices like the S&P 500 have behaved exactly as expected during the past decade. Thus far, there have been two cyclical downtrends and two cyclical uptrends.

Notice how volatility has increased over the past three years as the secular bear has matured. The first cyclical uptrend moved well into overbought territory when it peaked in 2007, becoming even more overbought than the final rally of the previous secular bull market. The index subsequently plunged to equivalent oversold extremes during the market crash in 2008 before reacting violently in early 2009. Now that the violence of the 2008 crash has been offset by an equally violent oversold bounce, a measure of balance has been restored. This can be seen in the technical indicators on the monthly chart above as momentum and price oscillators are holding near their respective neutral levels. The stock market now has a decision to make. Will the secular downtrend trend reassert itself, or will the countertrend rally from early 2009 continue?

Our Secular Trend Score (STS), which has correctly identified every secular trend change since the crash in 1929, clearly indicates that we are nowhere near the end of this secular bear market. The current STS of -51 is well into negative territory and it has yet to even approach positive territory since the secular bear began.

We can therefore conclude with a very high degree of statistical confidence that we are still several years away from the ultimate bottom that will provide the next great buying opportunity from a long-term investment perspective. However, the intermediate-term trend cares very little about secular inflection points. As we noted yesterday, the massive topping formation that we have been monitoring for the past several months has entered an important phase of its development.

After closing well below long-term congestion support in the 1,060 area in late June, the market rallied back above that level before moving above downtrend resistance this week, confirming the start of an uptrend from the beginning of the month. The current uptrend also developed out of an Intermediate-Term Cycle Low (ITCL), suggesting that time is supportive of the move as well, at least until the end of August.

How this rally responds over the next five weeks should tell us a great deal about the health of the long-term trend. If the S&P 500 continues to gain strength and approaches the April high near 1,217, the bullish scenario will be favored and another long-term breakout will become more likely. However, if stocks struggle to move above the June and January highs at 1,123 and 1,150, respectively, the new cyclical downtrend scenario will become a virtual certainty.

Our analysis continues to favor the cyclical downtrend scenario as it has since early this year. Equities have exhibited prototypical topping behavior since the peak in April, and the recent confluence of historically reliable recession signals further supports the current message of the markets. Over the next five weeks, we believe the stock market will likely behave in a manner similar to the same period in 2008 when the S&P 500 moved essentially sideways during August before heading decisively lower in September. As always, there are no certainties in the financial markets, only possibilities and probabilities. The next few weeks should provide a great deal of clarity, so stay tuned.

Disclosure: No positions