Will the Market Selloff Continue?

Barron’s

The technicals suggest that U.S. stocks are oversold at this point. But let’s be clear: All is not well.

After nearly two weeks spent in a free fall, the bears may have gotten a little bit ahead of themselves. With the Dow Jones Industrial Average down 18 points in late-day trading Wednesday, it appeared that the Dow was set to register its ninth straight day in the red. So expect a modest recovery in the near future as bears take some profits.

From a technical perspective, just about every sector has fallen very far in a very short amount of time. This condition is called « oversold » by technical analysts, and it often results in a rebound, albeit a temporary one. I like the analogy of a rubber band stretched too tightly. Either it breaks or it snaps back to relieve the excess tension. Since market crashes are rare, more likely we’ll see it snap back. There is never a guarantee, but we’ll go with the odds on this one. Whether it rebounds a little or a lot in the near term, the long-term picture is not pretty. The stock market is on the edge of a major change in trend from sideways to down. In just the first few days of August, there have been several major — and bearish — developments.

The first, which grabbed the attention of many market pundits, was the market’s steep drop below the 200-day moving average, a key metric of trend direction. In June, the Standard & Poor’s 500 traded lower to meet its average for the first time in nearly 10 months (see Getting Technical, « Meditating on a Popular Market Measure, » June 29). The Nasdaq actually dipped slightly below its respective average and stayed there for several days. In that case, however, the market’s overall condition was still robust, and the 200-day average acted as a support, or floor. But now, major market indexes have sliced through their respective averages like the proverbial hot knife through butter (see Chart 1).

The next widely watched feature is the giant head-and-shoulders pattern discussed here last week (see Getting Technical, « Giving a Cold Shoulder to Bullishness, » July 27). Without rehashing the details, it is a form of trading range that began in January and was broken to the downside Tuesday. I have my reservations about this being the last straw breaking the bull’s back, however. Breakdowns that occur on such an uninterrupted bout of selling have a habit of failing or at least thumbing their noses at the bears for a while. I would be much more comfortable calling it a breakdown had it paused a day or two before the break. Or, if it stabilizes a day or two right where it is now and then drops again.

The reason is that breakdowns are supposed to represent changes from the sideways action in a pattern to the vertical price movement of a trend. Declines that start at the top of a pattern, as this one did, and move through the bottom of the pattern may be the result of momentum.

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