Since reaching a panic low of 676 on March 9, the S&P 500 closed higher six consecutive weeks before finally pausing. Over that period, the index rose 29% in a methodical manner. Although those rallies are great to catch, they become difficult to trade. Nearly 80% of the rally occurred over the first three weeks and resulted in a trendline (green line) which was so steep that chasing the rally was extremely dangerous. Also, with the S&P having bounced from an extremely oversold condition, it became difficult to determine proper support levels and price targets. The S&P’s behavior over the last three weeks eliminates the conundrum.
Looking at the index since May 2008, a clear fan pattern (lines A, B, and C) has guided shares lower. A fan is a technical pattern where three trendlines of differing slope exist on the same graph. For prices to break the primary trend, all three lines must be broken. Until then, we should view countermoves as corrections within a long-lasting pattern.
With the S&P, most of the post-September meltdown has occurred beneath line A. On a few occasions, prices moved above the trend then quickly pushed lower. None of these rallies offered significant movement, indicating the potential of a reversal. The recent rally is the first where line B has been challenged and alters the picture.
On the first few attempts to violate line B, the existing trend pushed prices lower. Now we ask if that shall continue. Looking at the chart, we see the framework for a decisive challenge over the weeks ahead that would have significant ramifications. Were the S&P to move through this trendline and better its recent peak of 869, it would validate the current rally and indicate that market lows have been seen. Such a powerful move would target the 200-day moving average (MA) as the next price target before beginning a final assault of the primary trend. However, were the opposite to occur, it raises the possibility that the low of 676 will be retested and indicates that this bear market is not nearing completion.
Examining the current price of the S&P versus each target, we have the makings of a beautiful short trade. Were the market to go higher and better the recent peak, someone short would suffer a 1.4% loss. However, if the trendline does offer stiff resistance and the March lows are revisited, they would see a gain of 22%. Anytime I can risk 1.4% to make 22%, it is a trade worth doing.
We will be using the SPDR Trust (SPY) as a proxy for the S&P 500. Currently, the portfolio my weekly newsletter EPIC Insights has a 2% short position in this security. Considering the attractive risk versus reward tradeoff, I recommend an additional 3% short position in SPY as this week’s technical trade. Use a close above 869 as a stop loss to exit the entire short position.