Looking back at the action in the stock market over the last few days, the S&P 500 appears to have broken down with the S&P 500 tumbling from a new high of 1314.07 last Friday to a close on Tuesday of 1286.57, a decline of 27.50 index points or 2.09% in just three days.

What’s that? ….So what? -- you say. True enough, a decline of 2% in today’s market doesn’t seem like much, but in my view, this latest 2% reversal speaks volumes about what could be coming next... a preview of coming attractions so to speak.

Note that with Tuesday down 10 pt S&P close, the S&P cracked its rising trendline going back to the important lows of October 2005. Note also, that the S&P closed below its rising 50-day moving average—and most importantly—has broken back below the 1295 area, which was the zone of the previous highs seen on January 11^th at 1294.86 and February 27^that 1297.23.

In late March, on March 28^th to be specific, that 1295 held as support, which would have been the normal technical expectation following a break out above resistance. The normal sequence being, you break out to the upside, pull back to support, and then move off to the upside once again with increasing momentum and volume. No such luck on this occasion. Instead, we see a breakout, followed by a pull back, followed by a poor quality rally on failing momentum (see RSI divergence lower clip) followed by an under-cutting of the prior support.

In essence what we see here is a “false breakout” + “end run” scenario with market doubling back to the downside. In my view, there is just no doubt that an important medium-term top is now in place for the S&P 500.

RUSSELL 2000 ROLLING OVER

What about some of the other stock market indices? How do the technicals look for some of the big market leaders? When one thinks of market leadership over the last few years, Small Cap Stocks in general have been “HOT” and have been unquestionably among the market's most consistent leaders. With that in mind, let’s take a look at the chart of the Russell 2000 index shown below. Does Tuesday’s action look encouraging to you?

Like the S&P, the long-time, leading Russell Index appears to be “rolling over” after having completed a five wave advance. Tuesday’s Russell decline actually outpaced the S&P on the downside. Over the next few days, the key area to be watching will be the 740 area on this index as a break below 740 would add more fuel to a building, bearish outlook for the stock market.

S&P 100 - OEX INDEX Unweighted - A/D LINE MAKING LOWER HIGHS

In addition to the recent early signs of weakness in key indices like the S&P and the Russell 2000, what is particularly troubling about the current market outlook is the long pattern of internal technical deterioration, which has preceded the most recent short-term top. Take a look at the chart above where we see an Unweighted version of the S&P 100 and immediately below it, the A/D Line for the same index. Note that over the last 6 months, as the OEX Index moved to a series of ever higher highs, the Daily Cumulative A/D Line for the component stocks has been making a series of lower highs. Worse yet, over the last few days, as selling has picked up on the major indices, the OEX A/D Line has actually undercut its now declining 200-day moving average. This is not a healthy condition for the stock market and argues for a more serious correction to continue in coming weeks.

TWO YEAR INTERNAL DETERIORATION CONTINUES

In addition to the poor action from the A/D Line, the pattern coming from the stock market has been one of “progressive” internal deterioration for the balance of the last two years. 

In the chart above, I show the S&P 500 on the top clip. Below it, I've included a cumulative volume gauge for the NYSE, which excludes all securities except operating companies. In looking at the cumulative volume curve, we see a clear cut rising wedge formation wherein each rally of the last two years has been progressively weaker. More to the point, the most recent advance on the S&P saw this gauge unable to materially better the highs seen on January 11, 2006 — setting up yet another bearish divergence.

CUMULATIVE VOLUME DETREND OSCILLATOR CRIES RED FLAG!

Taking the above analysis one step further, we can “detrend” the Cumulative Volume Curve by computing the percentage above and below the 200-day average for the indicator. By performing this calculation, we can see in even clearer terms that as the bull market in the S&P has progressed to the upside in recent years, each advance has become progressively weaker with the Cumulative Volume Detrend Oscillator making a long series of lower highs. If this does not cry out as a big “red flag” than honestly, I do not know what would. There have now been four (count ‘em) higher price highs on the S&P, accompanied by four lower highs on the Detrend Oscillator.

CONSIDER TIME SPAN ANALYSIS

In addition to deterioration within a variety of technical gauges in both of the previous charts, I show the S&P 500 with its 200-day Bollinger Bands. In my work, I am constantly keeping track of what I call long dated “Time Spans”. While most of us spend lots of time looking at what IS happening in the markets, on too many occasions, we fail to recognize events which are cyclical in nature that have NOT happened in a long period of time.

Time Span analysis centers on asking the question, what has not taken place in the market (that is a relatively normal event for the market) in a very long time? To be effective, you need to look at indicators which I would characterize as having a pendulum affect. Overbought and Oversold gauges and Trading Bands are two good examples. If you see an indicator like RSI, for example, that may not have seen an oversold reading in a long period of time—and you know RSI goes back and forth between overbought and oversold with high levels of regularity—at some point, the fact that so much time has elapsed tells us that an oversold event is becoming a big probability. The same thing applies with the trading bands where prices routinely move back and forth between the upper and lower band.

Time Span Counter

In the case of the S&P 500 and its 200-day trading bands, we are talking about a long-term set of bands. In order to reach the lower band, it will take a “big move to the downside with that band currently positioned at a reading of 1177.15.

Now, guess what? The last time the S&P 500 made contact with its 200-day lower band was October 11, 2002. To be more precise—through Wednesday’s close—it has now been 881 trading days that the S&P has gone without hitting its 200-day lower band.

In the chart above, I plot a “Time Span” Counter, which tracks the number of trading days the S&P has gone without hitting the 200-day lower band. As you can see, going back over the last 36 years, this is the second longest streak ever seen. Can you say “Major Stock Market Correction – DEAD AHEAD?” In order to end the Time Span, the S&P must go down and tag the band ,which from current levels of 1290 implies a minimum additional decline of 8.7%. In my view, the 1170 area when reached will in all likelihood not be strong enough support to hold the market and instead, prices will likely need to fully retest the more prominent lows in the 1080 to 1100 area for the S&P. That would bring the total decline to percentage total closer to 15%, which would be no fun for anyone’s portfolio.

PARABOLIC CHARTS SIGNAL CAUTION

With respect to individual market sectors, at the present time I am most concerned about the outlook for the Natural Resource sector where I have long been a super bull. That said, in looking at the charts of many names in the Steel sector (Commercial Metals, Titanium Metals, Tenaris, Nucor), Base Metals (Freeport, Phelps Dodge, AUR, BHP) and the Rails, which transport raw materials, I find it hard to believe that a serious set back isn’t in the offing. Many of these charts looks virtually parabolic.

It is in the nature of parabolic price charts to peak out very quickly and retrace large chunks of the advance in very short periods of time. Consequently, while it is hard to be perfect on short-term timing, the weight of the technical evidence suggests that now is a good time to be raising cash and adopting a progressively more defensive posture cutting back where early signs of weakness develops.