Stocks: The Bear Is Growling

S&P thinks the Fed is running out of time to prevent a real decline in the equity markets

So much for the seasonal strength we were expecting. November was tough with the S&P 500 dropping 4.4%. No rebound in December either, as the "500" fell 0.86%. This has been followed by an ugly start to January.

When the market does not follow its normal seasonal patterns, we think something could be very wrong. We are therefore turning more cautious on the market for the next three to six months, and believe the chances that the 10% correction that we've seen turns into something more like a 15% to 20% decline.

The one potential caveat to our dour forecast is the Federal Reserve, but we are not holding out much hope from them either. In our view, the Fed has been lagging in its loosening campaign since the middle of 2006. That is when the 2-year Treasury yield started to diverge from the federal funds rate. Up until the middle of 2007, the spread remained in the 50 basis point area. However, since then, the 2-year Treasury yield has plummeted to 2.8% from about 4.75% while the federal funds rate has only declined from 5.25% to 4.25%. The current spread of close to 150 basis points is huge on an historic basis, and is very close to what we saw at the end of 2000, another time when the Fed was behind the market.

Our point here is that we think the Fed is running out of time to prevent a real decline in the equity markets, and unless we start seeing some 50 basis point cuts or intra-meeting cuts, we think the bear may get the first laugh in 2008.

As far as the near-term outlook for the S&P 500, the index has broken down out of a symmetrical triangle that it has been tracing out over the past couple of months, a bearish sign in our view, and this suggests we will see another critical test of the 1407 area. This level represented the closing low in August and November and a failure in this zone would be a major technical breakdown for the market, and we believe would open the door to another 5% to 10% on the downside.

Before there is a test of the 1407 area, the S&P 500 must first break trendline support off the lows since July 2006, and that sits at 1425. The 80-week exponential average is in serious danger of giving way today as it lies at 1431. This would be the first weekly close underneath the 80-week exponential since a very minor break in August, 2004. This average has done a great job of providing support for the S&P 500 during the bull market, and a major break would be another arrow in the bull.

If the S&P 500 takes out the 1407 level, the index will have completed a fairly large double top with a width of 158 points. Some are calling the current topping formation a diamond top, but whatever it is, it's big and ugly. Subtracting the width of the pattern from the breakdown point of 1407, gives us a potential measured move down to 1249. This is almost exactly a 20% decline from the October 9 high of 1565. This also equates very closely to a 38.2% retracement of the entire bull market, which would target the 1264 level.

A break below the recent closing lows would most likely turn our longer term charts and indicators bearish, suggesting more damage and that possibly a bear market lies ahead. The 17-week exponential average is very close to breaking below the 43-week exponential average, based on the S&P 500, and this would be the first bearish crossover since November, 2000. That bearish cross in 2000 did an excellent job of keeping investors out of most of the bear market. The signal reversed in June 2003 with a bullish crossover, and has kept investors in for the majority of the current bull market.

On top of this price chart, we plot the 43-week relative strength index (RSI). Basically, when the RSI is above 50, the market is in a bullish mode, and when the RSI drops below 50, it suggests the market is in a major bearish trend. With the current reading of 51, the RSI is getting very close to signaling major trouble for the stock market. The last signal from the 43-week RSI was bullish and occurred in June 2003.

Another combination of moving averages we like to use to determine the major trend of the market is the 10-month and 20-month exponential averages (EMA). The S&P 500 is currently sitting below its 10-month EMA and if we finish January underneath this average, it would be the first monthly close below the 10-month since the break in November, 2000. In addition, the 10-month EMA is declining for the first time since late 2000. The 20-month EMA, which has provided great intra-month support for the S&P 500 during the entire bull market, is sitting at 1427, and a monthly close below this average would be the first since late-2000.

On top of this chart sits the 13-month RSI. Above 50 is considered bull market territory while below 50 is considered bear market territory. The 13-month RSI is at 55 and has traced out a series of lower highs and lower lows since May, 2007.

Another worry is the continued deterioration of market internals. The NYSE advance/decline (a/d) line peaked in June, 2007, and has not kept pace with prices. The a/d line is very close to breaking down below the recent lows traced out in November and August. The other internal concern is that volume is not keeping up with prices. While prices on the S&P 500 were making new highs in October, the NYSE a/d line of advancing and declining volume failed to move to new highs. During healthy markets, the a/d line and a/d volume line should at least mirror prices. Sometimes, the internals actually lead prices to new highs. The a/d line of volume is also very close to breaking the recent lows set in November and August.

While it is easy to look back at these internal failures, they sometimes provide huge lead times as the NYSE a/d line peaked in April, 1998, well before the 2000 peak, while the Nasdaq a/d line of volume peaked concurrently with prices.