Market will Likely Commence Falling this Week

The broad U.S. equities market, as measured by the Dow Jones Industrials and NASDAQ Composite, flashed a bearish signal late last week and will likely experience weakness over the next several days.

Our basis for this assertion is the daily bar chart for both the Dow and the NASDAQ. For the week ended Aug. 20, the Dow closed at exactly the 11100 level-and extremely important resistance level. In doing so the Dow formed a chart pattern known as a "tweezers top," where prices are halted at least twice or more by a chart resistance level that acts as a veritable brick wall and prevents prices from penetrating higher. The pattern usually precedes a sudden reversal, although the amplitude and intensity of the reversal cannot be forecast based on this pattern. In this case, the 11100 level has acted to constrain the Dow three times in the past week. Interestingly, this level was where the Dow met resistance back in May and it served to trigger a month-long decline that took the Dow as low as 10400. Once again, the Dow is up against the proverbial wall, and what happens this week will largely determine its course of travel over the next few weeks.

What makes the Dow's current position even more critical is the convergence of short-term and intermediate-term trendlines that is now visible in its chart. Looking at the daily bar chart for the Dow from April to the present, there are at least five distinctive trendlines that can be drawn from the 10400 level to its all-time high of 11200. All of these lines are parallel to one another and are sloping downward. These five downward trendlines are intersected by at least two parallel trendlines in the upward-sloping direction. In other words, this is where up meets down and where "East meets West," and for the Dow to continue to trend higher in the weeks ahead it must find support at approximately the 10600 level (where an important upward trendline is located). Conversely, if 10600 fails to hold during this week's expected decline, it will imply that the collective forces of the downward trendlines have won out over the forces of the prevailing uptrend, and these lines would likely shepherd the Dow to considerably lower levels in the weeks ahead. The present week, therefore, is an extremely important one for determining the market's near-term direction.

Not coincidentally, this week (Tuesday, Aug. 24, to be exact) is the date of the Federal Reserve Board's interest rate meeting, where they will decide whether to raise or lower interest rates. It is generally expected by most investors that the Fed will indeed raise rates, as Fed Chairman Greenspan's comments of late have been quite hawkish. Perhaps the bearish technical position in which market presently finds itself is in anticipation of a rate hike. We'll all know for sure on Tuesday.

Meanwhile, the NASDAQ Composite index, in closing on Friday (Aug. 20) at 2648, met a resistance level that was established in April. This corresponds very closely with the chart pattern visible in the Dow, and both patterns resemble a classic head and shoulders top. As the name implies, this pattern resembles a "head" with a "shoulder" on either side, both of which are at a level lower than the head and typically even with each other. In the case of the Dow, the head is formed at the 11200 level while the right and left shoulders both peak at exactly the 11100 level. The "neckline" (or support level for the pattern) is found in the area between 10500 and 10600. The head and shoulders pattern almost always implies that distribution has been underway and that prices will fall once the pattern is completed.

Another area of concern has been the uncharacteristically low volume that has attended most trading sessions over the past few weeks, regardless of whether the trading session ended higher or lower. This is unusual to the say the least and could be interpreted in any number of ways. The general rule of thumb is that volume tends to expand in the direction of the major trend and contracts during counter-trend corrections. Under this interpretation, the low volume that has attended most trading days lately would be seen as nothing more than a consolidation or pull-back prior to a continuation of the prevailing upward trend. However, it is also true that volume often peaks prior to prices, and low volume can occur in the early stages of a bear market immediately prior to a major decline. Once the decline picks up steam, volume would be expected to increase. So this "limbo" stage the market presently finds itself in could either be a brief correction just prior to another upsurge in prices, or it could be the preliminary stage of an incipient bear market. Time alone will tell.

However, we received a most interesting correspondence last week that goes a long way toward addressing the "volume question."

A reader who identified himself as a trader affiliated with a hedge fund in New York sent us the following e-mail. We will protect his identity but quote at length from his letter:

"…I believe, however, many people are missing the true signs that this market has topped. First, low volume frequently accompanies the first leg of a sell-off because so much informed selling will have occurred on the way up and near the top. Witness the uninterrupted (by accumulation) distribution days (down or flat days on increased volume) in the Dow in the 11000-11200 level (4/30, 5/4, 5/6, 5/14, 5/18, 5/21, 5/24). The specialists appear confident meeting demand with shorts here and they know how to [sell] short without moving price. Then [the formation of] the head (7/6, 7/8, 7/13, 7/20, 7/26). Now the [right] shoulder could be starting.

"We also like to watch the SPY as the specialist can short here without specific stock risk. There has not been any accumulation (for an index 1% up on increased volume from the prior day, for a stock up on greater than 50-day average volume and prior day's price) here on this bounce. Distribution [occurred on the following days:] (7/6, 7/12, 7/13, 7/19, 7/20, 7/22, 7/29, 8/4, 8/10).

"Other signs [pointing to a top]-accumulation short cover rally on 7/27 failed-next rally 8/5 failed. August 13 next accumulation in Dow (SPX refuses to confirm), so the lows of 8/13 are extremely important."

Indeed, the August 13 low to which this trader refers is at the Dow 10800 level, which also is an important intermediate support as well as a level where at least one trendline intersects. It will do us well to watch this level closely in the days ahead as it will likely prove to be a critical turning point one way or the other.

In order for the bearish scenario outlined above to be invalidated, the Dow must decisively rally on increasing volume throughout most of this week. It is also imperative that the Dow penetrate resistance at 11200 (the previous all-time high) and set a new high. This would go a long way toward establishing the case for an ongoing healthy bull market. If this fails to materialize, however, it will support our case for a bearish marketplace for the remainder of the year. Again, this week-particularly Tuesday-will most likely provide the answer.

Our technical indicators are flashing mixed signals, which only adds fuel to the already volatile state of the market and will likely serve to intensify the next major move the market chooses to take (whether up or down). Short-term momentum (as measured by the 10-day Rate of Change (ROC) oscillator) is in a technical uptrend, coming as it is off an oversold level in recent weeks, but appears to have run out of steam and has peaked at a lower level than the previous peak. This sets a pattern of lower highs and lower lows on its chart, which is a sign of weakness in the market. The 30-day ROC oscillator is likewise reflecting weakness in the market as it is currently below its equilibrium (or "zero" line) and is etching out a bearish descending triangle pattern. All of this points to declining momentum in the days/weeks ahead, which translates into lower stock prices.

Volume indicators are looking bearish, as well. The chart showing 5-day NYSE Advancing Volume is now in a technical downtrend, which means fewer stocks are being accumulated. NYSE 5-day Declining bearish as the chart for advancing volume, but is starting to pick up, wh means more selling is taking place.

The Internet sector is looking increasingly bearish, although it cannot yet be forcibly asserted that a bear market is forthcoming. All the signs, however, are pointing towards a bear market. For instance, a composite chart of the five leading Internet stocks shows a giant head and shoulders pattern as well as a giant descending triangle pattern at the same time. Both patterns are bearish in their implications. The Internet index is resting at its critical support level (which would correspond with the "neckline" of its head and shoulders pattern). This means that prices must either accelerate now in order to change the trend from bearish to bullish, or else prices will likely break below neckline support and begin falling. As well, most of the leading Internet stocks (including AOL, Yahoo, and Amazon) are showing the exact same descending triangle pattern in their charts. Since prices in each case are at the theoretical "apex," or point, of the triangle, a breakout (whether up or down) is near. Once again, we believe the present week will tell us where the Internet sector is heading as we head into the final months of the century.

In conclusion, we urge traders and investors to exercise the utmost caution in their market operations in the coming weeks. We have entered a timeframe of great uncertainty in the financial arena-particularly in the equity markets-and the combination of investor nervousness over a rise in interest rates, the possibility for a Y2K computer crisis, and a possible recrudescence of the overseas financial crisis has contributed greatly to the volatility in the U.S. stock market. As if that isn't enough, seasonal and cyclical patterns are converging in a way that leaves the market in a potentially weak position. Our advice is to tread carefully in this market environment and employ prudence in all your investment decisions.