Is the Stock Market Still Vulnerable?

The stock rally over the past week has relieved some investor fears, but deterioration in the market internals suggest that stocks are vulnerable to a further decline, and a more defensive stance is warranted.

The earnings this week, along with the better-than-expected reaction to the Spanish bond auctions have reduced the high level of fear that was evident at the April 10 lows. From a technical standpoint, the rebound from these lows has now reached a critical juncture.

The S&P 500 has just retraced over 50% of the recent decline. The 61.8% Fibonacci retracement resistance stands at 1397.55, and a close above the psychological resistance at 1400 will increase the odds that the highs at 1422.38 will be tested.

Conversely, a drop below Monday’s lows at 1365.38 will return the focus to the downside. On a break of the April 10 lows, the S&P 500 could drop another 2%-6%. The intermediate-term analysis still suggests a deeper correction will be a buying opportunity, but there are some warning signs.

Sentiment is still too bullish, and many seem to be complacent now that there have been some positive earnings surprises. Also the Commitment of Traders (COT) data, according to commodity expert John Person, reveals that small speculators added to their long positions last week.

Historically, small speculators do not have a great track record of being on the right side of the market. Let’s now look at the technical signs that have me concerned about the market’s short-term health.

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Chart Analysis: The daily chart of the Spyder Trust (SPY) shows that it closed below the daily Starc- band on last Tuesday’s lows at $135.76. This was clearly a high-risk time to sell. The rebound has taken SPY back to the underside of the former uptrend, line a.

• The key resistance overhead is at $139.76 (61.8% resistance) then and $140.34, the April 4 high
• Daily Starc+ band is currently at $140.95
• The NYSE Advance/Decline (A/D) line is the broadest measure of the market’s health, and it formed a slight negative divergence at the recent highs, line b
• The A/D line dropped below its weighted moving average (WMA) and the previous lows on last week’s decline
• A drop below the April 10 lows would start a new downtrend in the A/D line, which has longer-term support at line c
• The McClellan Oscillator hit oversold levels at -315 last week and has now bounced back to the zero line, which has relieved the oversold status

NEXT: The Preferred ETF for Going Short the S&P 500

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The short-term chart of the Spyder Trust (SPY) shows what may be an A-B-C rally from last week’s lows, as SPY closed Wednesday just below the flat 20-day EMA.

• Once below the April 10 lows, the next support (line a) is at $134.26
• If the next decline is equal to the drop from the April 2 high to the April 10 low, the 100% Fibonacci price projection, or equality target, is at $132.91
• Major 38.2% Fibonacci retracement support is at $128.92
• S&P 500 A/D line formed a negative divergence at the recent highs, line b, before breaking its uptrend, line c
• The S&P 500 A/D line shows a similar negative formation as the NYSE A/D line, as it has just rallied back to former support (now resistance) at line c
• S&P 500 A/D line was weaker than the NYSE on the decline, as the uptrend, line c, was broken

The daily chart of the ProShares Short S&P 500 ETF (SH) has pulled back to first support in the $36 area.

• SH had rallied from the April 2 low of $35.37 to a high on April 10 of $37.02
• Daily on-balance volume (OBV) broke its downtrend, line e, in late March and retested the breakout level at the April lows
• OBV also formed a positive divergence at the lows, line f, and is well above its rising weighted moving average
• There is next resistance at $36.78 -$36.85 and the downtrend, line d
• The 100% Fibonacci projection, or equality target, is at $37.67 with longer-term resistance in the $40 area

What It Means: The action of the stock market in the next two days is likely to set the stage for next week’s trading as well.

The most likely scenario, in my opinion, is for the stock market rally to fail near current levels and for stocks to eventually break below the April 10 lows. This would allow for several more weeks on the downside, but at this point, the probability for a several-month decline is low.

If stocks instead manage to close above key overhead resistance, then we could see a test of the early-April highs. Such a rally would have to be very impressive to signal a breakout to significant new highs.

New positions in the ProShares Short S&P 500 ETF (SH) are recommended for both traders and investors. For stock positions, be sure to have stops in place and raise them when necessary.

How to Profit: For the ProShares Short S&P 500 ETF (SH), go 50% long at $36.26 or better and 50% long at $36.06 with a stop at $35.18 (risk of approx. 2.8%).

Alternatively, the position could be taken by buying SH on a buy stop at $36.88 with a sell stop at $35.96 (risk of approx. 2.6%).

I have tightened many of the stop levels on the stocks in the “Charts in Play” Portfolio. See Page 3 for the current portfolio with updated stop levels.

NEXT: View the Latest “Charts in Play” Portfolio

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