The S&P 500 Interim Top

Adam Hamilton     August 15, 2003     2668 Words


Unlike the stupendous fireworks of last summer’s violent V-bounce, the equity-market action of this summer has been relatively tranquil and serene.  Both volatility and volume are running quite low as the near total lack of trading excitement has lulled speculators into a long summer nap.


But even though we have just witnessed a typically slow summer trading season, the last few months have still left us with much to ponder as we rapidly plunge into autumn, the notorious mean season for the stock markets.  The short-term trend in the US markets has already subtly changed with little fanfare, altering the autumn game dramatically compared to last spring’s enormous bear-market rally.


Instead of the sharp short-term uptrend that dazzled speculators this spring, a new short-term downtrend has already emerged and seems to be picking up steam.  This fading bullish momentum coupled with stellar general-equity valuations and extraordinarily high complacency is certainly interesting, perhaps even ominous, to behold.

The compelling combination of the recent pure technical price action, low volatility, high complacency, and lack of bullish enthusiasm looks an awful lot like a classical bear-market-rally topping signature.  With each passing day this apparent new major interim top looks more and more solid, suggesting that the last nails have indeed finally been hammered into the coffin of last spring’s monster war rally.


This week I would like to discuss this potential major interim top achieved in the US stock markets earlier this summer, primarily from a technical perspective.  Since the S&P 500 is the most important and most representative major stock index for the general US markets as a whole, this analysis is rendered through the lens of that mighty index.


While not widely discussed since it is definitely not a bullish development, the latest major interim top is quite apparent on a price chart.  The powerful war-rally uptrend has been decisively broken and a modest short-term downtrend has stealthily seized the helm as we plunge into the traditional autumn chaos.



This short-term chart encompasses about six months or so, beginning in those dark days leading up to Washington’s annexation of Iraq.  As soon as the American-taxpayer-financed bombs started obliterating Baghdad so we American taxpayers could get robbed yet again by Washington to rebuild it from the rubble, the stock markets took off like a cat with its tail on fire.  War is hell, but the markets were nevertheless relieved when the nervous pre-war uncertainty was eliminated.


After its initial blistering spike higher on the early adrenaline and euphoria of combat and neo-colonialism, the war rally settled into a nice tight uptrend channel that relentlessly powered higher for several months until mid-June.  The war-rally support and resistance lines are drawn on the chart above, and this truly was an impressive uptrend channel.  Fittingly for sporting such a solid uptrend pipe, the war rally blasted up over 26% in S&P 500 terms, easily the biggest rally of this entire Great Bear to date.


In early June the war rally valiantly tried to cast its technical bands asunder and break out of its uptrend channel to the upside, but it was repelled and the latest major interim top was carved.  On Tuesday June 17th the S&P 500 managed to reach 1015 intraday before modestly fading to a new closing high around 1012.  Its assault above its war-rally-uptrend resistance was short-lived though, as it soon collapsed back into its tight trading channel.


About three weeks later in early July the US markets once again reached for new highs and the S&P 500 even managed to close near 1008, but the earlier mid-June highs held strong.  The bullish momentum and initial war euphoria faded rapidly as the cold, brutal realities of military occupation became apparent.  American investors finally started to realize that the steep costs of the takeover of Iraq in the precious blood of America’s priceless sons, not to mention our hard-earned treasure, would be staggering.


Since their mid-June war-rally tops, the stock markets have been relentlessly decaying sideways in a series of lower highs and lower lows.  There have been at least four separate attempts at breaking out of this large topping pattern, but all have utterly failed so far.  These decaying tops at continuously lower levels betray the lack of bullish conviction and the rapidly fading momentum in the US stock markets this summer.  The balance of power is shifting!


By mid-July, the strong uptrend line of the war-rally support finally broke down.  Since then the S&P 500 hasn’t even come close to launching back into this uptrend channel, another important clue that the short-term trend has indeed decisively changed.  This large decaying topping pattern is illuminated in more detail in our next graph a little farther below.


By early August the new short-term downtrend managed to bully the S&P 500 all the way back down to its famous 965 neckline before it bounced modestly higher.  The mere fact that this long-term neckline is back into play will also cause a lot of trouble for the bulls, as all of the technical analysts trading from the grand strategic perspective will now want to tread cautiously and wait to see how the neckline situation resolves itself before deploying any more serious capital on the long side.


This S&P neckline bounce also carried the flagship index below its important 50-day moving average for the first time since the war rally launched.  Just this week the markets tried to rally back above this S&P 50dma, but so far they have not been able to make any real headway.  The plunge under and subsequent inability to break back over the 50dma is another sign that bullish momentum is rapidly evaporating before our very eyes.


In addition to this uninspiring technical action, both fundamental and sentimental extremes are also conspiring against the US markets at the moment, which may help to explain their lackluster behavior this summer. 


On the fundamental side of the ledger, the mighty S&P 500 is now trading near 26x earnings, almost officially back into classical bubble territory at 28x earnings!  Yikes!  On top of that it is only yielding 1.7% in dividends, which is incredibly low by all historical standards.  The raw magnitude of overvaluation remaining in this elite index, and indeed the entire stock market, continues to be breathtaking even three years into the Great Bear.


The bulls are desperately fighting a fierce fundamental headwind by trying to goose the markets higher from valuations as extraordinarily high as what we are witnessing today.  Until either US corporate earnings soar to justify these high stock prices or the stock prices plunge dramatically to reflect the lackluster corporate earnings realities, the shaky fundamental foundation today remains steadfastly opposed to the popular bullish dream of a new bull market in the midst of a Great Bear bust.


This ugly fundamental backdrop is joined by an astounding lack of popular fear.  According to the elite sentiment indicators like the VIX, there is effectively zero fear in the stock markets right now.  Virtually no one thinks the markets will ever fall again!  Complacency is one of the most dangerous emotions possible for investors and speculators.


The markets tend to like a nice balance between greed and fear, as when one emotion totally dominates the other it is usually a reliable harbinger of an imminent large sentiment swing in the opposite direction rapidly approaching to rebalance these grand emotional scales.  With greed and complacency virtually universal these days, the horribly skewed sentiment scene is also conspiring against the bulls.


The compelling combination of the technical decaying top, tremendously overvalued fundamentals, and widespread complacency is a powerful portent strongly suggesting that the war-rally top was indeed put in during June.  The vast majority of the technical, fundamental, and sentimental developments since then have been overwhelmingly bearish and the new short-term S&P 500 downtrend already reflects this popular sea shift.


As our second chart this week illustrates, the all-important technical price action is unambiguous in reflecting the new dominating short-term downtrend channel which is now unmistakably bearish for the US stock markets.  The days of the early war euphoria and rocketing stock markets are finito for now.



Since the war-rally bulls mysteriously went Missing In Action in mid-June, the S&P 500 and general US markets have been in a modest downtrend.  The current support and resistance lines are drawn in on the graph above.  They are even really well defined with over a week’s worth of trading days kissing both the bottom and top of this downtrend channel.


Of four separate attempts to break out of this strengthening downtrend channel and rekindle the war rally, all four have failed.  This new bearish downtrend also handily overpowered the old war-rally uptrend channel which was shattered in mid-July as the emerging short-term downtrend dominated the trading scene.


Even the winning streaks within this new downtrend channel lack the intensity of similar winning streaks in the final weeks of the war rally.  Our recent five-day winning streak that ended this week was significantly smaller in both overall price and percentage terms than the two five-day winning streaks leading up to the climax of the war rally.  This is yet another clue that the bulls have lost their momentum and are losing out in the fight for short-term market dominance.


Overall, there is no doubt that the short-term technical picture for the US stock markets is now bearish, just as the long-term charts have been for years.  The war rally was sharp and violent and spectacular, but it is likely finished since there has been no follow through whatsoever since mid-June.  Whether you trade using charts exclusively or merely integrate technical analysis into a broader trading approach, the only conclusion you can reach based on this summer’s S&P 500 action is that the bears are regaining control.


If the mid-June highs do indeed prove to be the major interim top capping the war rally, what does this mean for investors and speculators?  The implications of this development are widespread and profound.


A lot of folks have conveniently forgotten since March, but we are in a brutal once-in-three-generation Great Bear market!  The Great Bear began when the NASDAQ bubble burst because its valuations were absurd and totally unsustainable.  Once a Great Bear is unleashed from its lair after an index crash from a bubble top, there is absolutely nothing on Earth that can stop the beast from carrying out its brutal work to full completion.  This means mercilessly readjusting stock prices back down low enough so they are actually fundamentally undervalued.


In history undervalued general-market levels always run under 10x earnings and over 6% in dividend yields.  With the S&P 500 still trading near 26x earnings and only yielding 1.7% today, the Great Bear still has a lot of work left ahead of it.  Either the US stock markets will plunge again as in the 1930s or they will grind lower over a decade as in Japan in the 1990s, but one way or the other the Great Bear will maul stock prices back down to undervalued levels relative to the earnings and dividend streams they are able to spin off for investors.


While the primary Great Bear downtrend spawned by these Valuation Wave mean reversions can certainly be interrupted from time to time by powerful bear-market rallies, these rallies in no way alter the overall strategic downtrend.  Although the war rally ran up 26% in only three months, no doubt impressive, there have already been four other massive bear-market rallies since 2000 before the war rally that witnessed similar gains.  2001 witnessed 19% and 21% S&P 500 bear-market rallies while 2002 saw two back-to-back 21% specimens.


Extraordinarily powerful bear rallies are par for the course for a Great Bear.  These rallies blow off speculative steam and enable the bear not to scare away everyone too fast.  The total wealth destruction during a Great Bear is astonishing, and it wouldn’t be able to happen if the screws were ratcheted up too rapidly and people were scared soon enough to still have time to get out of Dodge. 


Like the proverbial frog in the pot, the Great Bear warms the water slowly to boil its prey before they are even aware of the danger.  Continuing modest losses over time, few of which individually seem deadly, eventually add up into a giant loss which totally annihilates the gross speculative excesses of the preceding bubble.  Capital death by a thousand cuts! 


Major bear rallies help most folks remain in denial about the reality of overvaluations and the Great Bear, so they are seduced into riding the markets right into the ground at the Ultimate Bottom.  Bear rallies deftly camouflage and obscure the true nature of the bear market.  Great Bears always work this way in history.  They are incredibly deceptive and dangerous periods of time for investors.


If the war-rally major interim top truly is in, this means that the Great Bear primary downtrend will reassert itself sooner or later here with a vengeance.  And when the new short-term bearish downtrend, the bubble-like valuations, the extraordinary popular complacency, and the reaction after the biggest bear rally in the whole bust are combined with the traditional autumn weakness in the stock markets, the results could be explosive.


Interestingly, I suspect that the S&P 500 can fall to 800 or so before the average bull starts getting really concerned.  Between here and 800 the bulls will claim that we are just in a big trading range and few will get worried.  The S&P 500 has bounced near 800 three times recently, last July, October, and this March, so many bulls feel that 800ish is the ultimate bear-market bottom.  They are wrong of course since no stock market in history has ever carved a long-term secular bottom at valuations anywhere near this extreme, but the bulls doggedly believe their own hype nevertheless.


Once 800 decisively breaks though, watch out below!  At that point the awful realization will set in that the Great Bear is not over and new lows have yet to be made at some unknown depth.  The fall of the 800 medium-term S&P support will likely spawn a huge wave of selling, which will put heavy pressure on the markets.  Until this 800 number is reached however, the continuing short-term downtrend is unlikely to spook the bulls into dumping shares en masse, at least if it maintains its present modest downslope.


Even though few believe it yet, the technical price action witnessed this summer strongly suggests that the latest interim top is in and the next major move will be to the downside for the stock markets.  Bullish momentum is gone, the short-term trend is already down, and the dangerous autumn trading season is almost upon us.


Couple these technical warnings with a vastly overvalued market three years into a brutal Great Bear bust and the situation gets really interesting.  We could really be in for a volatile and exciting autumn!  Investors should set relatively tight stops on their long general-equity positions and get ready to be stopped out if the action turns ugly to the downside.  The gunslinging speculators, of course, should prepare to play this bearish convergence by throwing short or buying put options.


As this downtrend accelerates, at Zeal we will be layering in more new index puts positions in the coming months to play the powerful convergence of these bearish technical, fundamental, and sentimental factors.  If you are interested in seeing or mirroring these actual trades, please consider joining us today.  We currently offer an acclaimed monthly newsletter and a separate anytime e-mail alert/update service to our subscribers in more than 45 countries around the globe.


I am very excited to see what this autumn may bring for the markets and am looking forward to trading accordingly as the great opportunities for index speculation arise.  After a relatively dull and listless summer, it will be nice to have a shot at a volatile and exciting autumn as the Great Bear continues its delayed revaluation work.


Adam Hamilton, CPA     August 15, 2003     Subscribe