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Is There Enough Blood on the Street to Start Buying?

May 25, 2012
Simon Maierhofer

The S&P has fallen 130 points from its April 2012 high. This has done some technical damage. How bad is the damage and will the S&P be able to recover like it did in 2010 and 2011?

Damage – whether a damaged car, iPhone or stock chart - is never a good thing, but it’s not always irreparable.

How serious is the S&P’s technical damage caused by the recent 130-point decline? Will stocks (NYSEArca: VTI) be able to recover like they did in 2010 and 2011?

Damage Report

How serious is the damage caused by the S&P’s drop from 1,422 to 1,291? If we were talking about a collision, the car would need some bodywork but isn’t totaled.

The chart below – published in the April 20 ETF Profit Strategy Newsletter - compares the S&P’s current “accident” with the accidents of 2010 and 2011.

The chart highlights three dotted green support lines. The first kept the March 2009 – April 2010 rally going, the second outlined the July 2010 – May 2011 rally and the third support line originated from the October 2011 lows.

              

The April 20 ETF Profit Strategy Newsletter noted that: “The DJIA (DJI: ^DJI)), Nasdaq (Nasdaq: ^IXIC) and now the S&P (SNP: ^GSPC) have broken below trend line support going back to the October 2011 lows. In 2010 and 2011 a similar breach of trend line support led to sharp declines.”

Just in Time

The most recent trend line break was a bit messier than in 2010 or 2011 and required more navigation skills. Nevertheless, by combining trend line support with other technically significant support levels, the ETF Profit Strategy Newsletter was able to predict the onset of the recent decline when it warned via the May 3 update that: “A move below 1,386 will be a sell signal (as in go short).”

At Cross Roads

Since then, the S&P has fallen as low as 1,291, which has turned investors and Wall Street quite bearish. In times past, this level of bearish has often served as springboard for stocks to rally and there’s reason to believe that stocks may be close to a temporary bottom.

The chart below plots the S&P 500 against the percentage of bullish advisors polled by Investors Intelligence (II). The red dotted horizontal line highlights when sentiment was at similar levels.

             

Similar readings in February 2010, July 2010 and October 2011 lead to massive rallies. However, there is one major caveat: When bearish sentiment failed to spark a rally, it was followed by washout declines in January 2009 and July 2011.

Rally or Washout Decline?

There’s a big difference between a tradable rally and a washout decline. How do you separate the two and make sure you’re betting on the right direction? Simply put; support/resistance levels. I expect a bounce as long as the S&P remains above support and a decline if it falls below.

To some extent, the current decline is shaping up to be analogous to last years decline. As the S&P fell towards the October 2011 bottom, the ETF Profit Strategy Newsletter highlighted two possible outcomes on October 2, 2011.

The primary outlook saw a major market bottom. Here’s what the Newsletter outlined had to happen for stocks to bottom: “We need a close below 1,121 to start the bottoming process. The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.”

The key support/resistance level was 1,088. On October 4 the S&P dipped to 1,075 intraday but closed above 1,088, exactly what was needed to mark a bottom.

The S&P would have to close below 1,088 to activate the alternate outlook, which saw much lower prices. The S&P’s performance, however, eliminated the alternate scenario.

Like in October 2011, the S&P now needs to say above support to activate the potential for a tradable rally. A break below support will unlock much more bearish potential.

The ETF Profit Strategy Newsletter pinpoints the target for this decline and highlights must-hold support. This kind of “active driver assist” prevents major “accidents” and keeps investors on the road to profits.

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