A Massive Reversal or Long Live the Fed

The markets are not out of the woods yet, but the Fed cut has probably put at least a short-term floor under the market

by Mark Arbeter From Standard & Poor's Equity Research

Quite frankly, it looked like the markets were going to crash on Thursday, led down by the absolute disaster in financial stocks. Fortunately, a funny thing happened on the way to the potential collapse. At about 1 p.m. Thursday, the financial stocks, as well as the rest of the market, found their footing, and the market had one of those dramatic reversals. Did the market know that the Federal Reserve was going to cut the discount rate, or did the market just bounce off of support? We may never know the actual reason, but it is sure interesting to think about.

Getting back to what we do know, Thursday's price reversal for the S&P 500 was 2.97% from intraday low to the close. This was the largest one-day, positive price reversal since March 17, 2003, which was right as the market was coming out of the last bear market. There is of course a big difference between the two days: For Thursday, we were recovering from a 2.6% intraday loss, while the March 2003 trade day was basically straight up from the start.

Some of the more notable upside price reversals, during a day in which the S&P 500 was down a lot during the day, have tended to occur at or near major market lows. The most recent was in March and February 2003 where we saw intraday losses of at least 1.3% followed by price reversals off the lows of at least 2.1%. There were also some major reversals off of large intraday losses in July 2002 and August 1998.

So are we all of the sudden "out of the woods?" We think not yet, but the Fed cut has probably gone a long way at putting at least a short-term floor under the market. One of the great things about technical analysis is that it provides the technician with clear and definable support and resistance levels. The problem is, and especially during a panic that we have been witnessing, is determining what piece of support is going to provide the ultimate floor for the market. Sometimes, we can pick the floor and other times we can only outline the possibilities.

The technicians, of course, have a solution to this dilemma, and that is to have "patience" and wait until a reversal pattern has been formed before jumping back in. So far, we have a panic intraday low down at 1370.60 and a closing low at 1406.70, but no reversal formation. If these two levels hold in the near term, and we suspect they will, the S&P 500 has quite a bit of overhead supply to deal with. Any rally into this supply has a very high probability of failing, in our view, and we think there should be some backing and filling, or a retest of the lows that we saw this week. As we have said many times, the double bottom is the most common reversal pattern at intermediate-term lows.

In our view, the technical reason why the market bounced so strongly on Thursday was that it hit chart support in the 1370 area from the lows in March. The intraday low on March 14 was 1363.98 and the closing low in March was 1374.12, right near Thursday's panic low of 1370.60. This chart support wasn't the only piece in the area, and this also may have been an important reason for the turnaround. The 65-week exponential moving average sits at 1412 and that is right near Thursday's close, and the 80-week exponential average lies at 1395. Lastly, using a standard scale on the y-axis rather than a semi-log scale which we almost always use, a long-term trendline off the March 2003 and July 2006 lows came in at 1365 on this week, just below the intraday low.

If the recent lows fail to hold, there is long-term trendline support, off the lows of the past couple of years, at 1330. The top of the next zone of chart support sits in the 1325 area.

As far as resistance goes, there is plenty of it, and it is dispersed pretty widely. In addition, and maybe more importantly, there is a cluster of positive days overhead that were accompanied by much larger than average volume. Many times, heavy volume days can provide very stiff resistance as the supply of stock in a certain area is quite heavy. The counter trend rally that occurred from August 6 to August 8 is a good example of heavy volume days on the upside. Each day, trading volume was at least 2.