A Topping Formation Is Taking Shape

The economy and the stock market usually don’t turn on a dime. Their behavior is more like an oil tanker, needing time and space to change direction.

In the stock market this shift is called a topping process and typically has two characteristics:

1. The range of its high to its low is between 10 percent to 15 percent with a relatively clearly defined lower boundary of support, often called the neckline by technical traders, and

2. It lasts anywhere from three to eighteen months.

Now look at the chart below of the S&P 500 …

After Thursday’s huge drop, a clear topping formation has suddenly emerged. Its neckline is defined by the lows of early November and mid-February. So Thursday’s low was an additional test of this already established trendline, which is rising slightly.

Source: Bloomberg

If you measure from the April high of 1,220 down to last Thursday’s low of 1,066 you get a range of 12.6 percent for this formation, thus meeting characteristic #1 of a topping process.

And if you go back to the starting point — that is the November low or the October low — we are in the seventh or eighth month, thus fulfilling the minimum time requirement for characteristic #2.

What to Expect Now …

I see Thursday’s drop as a warning crack signaling the end of the medium-term rally off the March 2009 low. A warning crack is a very steep, but short fall at the end of a huge bull move. Typically it’s followed by a rally back to the highs or even to token new highs. And that’s exactly what I’m expecting here.

Thursday had many ingredients of a panic move …

Especially interesting was the public’s urge to learn the reasons, or even the culprits, behind the massive plunge.

However, history shows that overvalued markets can hit air pockets, because everyone who is willing to buy is already invested. What’s more, value investors will not easily step in to buy a market with a monthly price-to-earnings ratio of 22.8 and a dividend yield of 1.9 percent.

Add it all up and you’ll understand why I think Thursday was an important day for the stock market. It probably marked a short-term low. But at the same time it signaled the end of the medium-term bull move.

There’s an old Wall Street saying: “Nobody rings a bell at the top or the bottom of a market.”

Well, I have to disagree …

Because Thursday’s warning crack was indeed a ringing bell. Sadly, though, most investors have decided not to listen.

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