A Key Test for Stocks

If the S&P 500 falls through support in the 1440 to 1465 range, things could get very ugly, very quickly

by Mark Arbeter From Standard & Poor's Equity Research

Intermediate-term pullbacks and corrections during bull markets seem to come in at least two flavors: A lot of pain all at once, or mild pain that lasts weeks or months. Obviously, the late-July slide is the first variety. In other words, the faster the drop, the quicker the bottom.

While technical analysis is our bread and butter, we think following the indicators we discuss each week becomes especially important in times of exaggerated market moves – like the ones we saw last week. Why? Technical analysis takes the emotion out of the entire investment decision. It also gives us definable targets to look for.

That said, while we made some cautious statements in our comment last week, we missed raising the red flag and while it is our hope and desire to call all the intermediate-term moves before they happen, not wait until certain supports are broken to shout sell, our crystal ball is dirty but hopefully not broken.

The S&P 500 completely obliterated all pieces of short-term technical support during its extended sell-off last week, very similar to the February pullback and the one last summer. On Tuesday, the index broke underneath its 50-day exponential moving average, and on Thursday, all hell broke loose. The index slid right through the 65-day exponential and 80-day simple moving averages for the first time since late February.

The "500" then sliced through the double bottom lows formed in June at the 1490 zone. The index then proceeded to plunge into an area with no real definable support, in our opinion, declining all the way to 1465.30 on an intraday basis.

Right below Thursday's intraday low is a stack of technical supports in the 1440 to 1465 range. We not only think this zone will be tested but also believe that this area of support must hold or things could get very ugly, very quickly. The S&P 500 bounced off the first piece of support Thursday, and that is the trendline drawn off the closes since last July. A similar trendline drawn off the intraday lows since last summer sits at 1450. The first piece of significant chart support, from the February high, is at 1460. A 50% retracement of the rally from March to July targets the 1463.60 level, while a 61.8% retracement comes in down at 1442.50.

It is likely that there will be a lot of talk about the 200-day moving average and its importance for providing support for the S&P 500. The 200-day simple average is at 1448 and the 200-day exponential average lies at 1450. We do not know why this average gets so much press but we think it is not a good indicator to use for timing the overall market.

For instance, since the bull market began, both the 200-day simple and exponential averages have been busted on four occasions, and the "500" then proceeded to reverse back to the upside. The 200-day exponential average did provide nice support during the March pullback, but it is just not a consistent winner at timing the longer-term moves of the market.

We prefer to use the 325-day exponential moving average, which correlates to a 65-week average. This line provided a floor for the S&P 500 in August 2003, August 2004, April 2005, and September 2005. It also acted as support, although not perfectly, in the summer of 2006.

In addition to the 325-day average, we also monitor a set of simple, moving average crossover systems that many times have done a very good job of keeping you in during bull markets and out during bear markets. We look at the 13-week exponential average vs. the 34-week exponential as well as the 17-week exponential average vs. the 43-week average. Thirteen and 34 just happen to be Fibonacci numbers.

We use these crossover systems in a number of ways. For instance, when the market has been rallying on an intermediate-term basis, and the gap between the two becomes wide, the likelihood of a pullback or correction rises. When the "500" drops below the 13-week or the 17-week, caution is advised from an intermediate-term standpoint.

But the real value for timing the market from a longer-term perspective is to watch for bullish and bearish crossovers.