S&P 500 Breakdown Could Signal Bear Market

The S&P 500 sold off through the February low after Wednesday's Federal Reserve interest rate decision and is now trading at its lowest level since September 2017. The instrument joins the Russell 2000 at a new 2018 low, while the Nasdaq 100 is still trading around 200 points above its February low. This potent combination predicts that the tech-heavy index will play catch-up in coming weeks, joining its rivals.

The sell-off confirms October's S&P 500 breakdown through the 200-day exponential moving average (EMA) following a two-month test, signaling a technical bear market while setting the stage for even lower lows in the first quarter of 2019. Market players should watch relative positioning between these indices closely during this period because a Nasdaq 100 breakdown would shift market energy from bearish divergence to bearish convergence, often a precursor to a volatile selling climax.

SPY Monthly Chart (2014 – 2018)

Chart showing the performance of the SPDR S&P 500 ETF (SPY)

The SPDR S&P 500 ETF (SPY) stalled above $210 in December 2014 and ground sideways into an August 2015 breakdown that established new support near $180. It tested that level in the first quarter of 2016 and turned higher, completing a breakout following the November election. The index posted impressive gains throughout 2017, finally topping out at $287 in January 2018. Sellers then took control, generating a volatile two-week decline into $252.92.

A series of higher lows on the 200-day EMA built support in the $250s, ahead of a rally wave that completed a round trip into the prior high in August. The subsequent breakout stalled just seven points above the January high, giving way to a reversal swing that trapped many trend followers. The decline settled near $260 in October and carved a rectangular consolidation across the moving average, breaking two- and 10-month range support this week.

The sell-off that started in September broke a 10-month rising channel on Dec. 14, establishing new resistance between $260 and $263. The index landed on the .382 Fibonacci retracement of the 2016 to 2018 uptrend at Wednesday's closing bell, raising the odds for a bullish stand around $250 (2,500 on the futures contract). A bounce that reaches broken channel support could offer a short sale opportunity for aggressive market players taking exposure above $260.

Replay of January 2016?

An alternative but equally bearish scenario could play out in the coming months. Price action since the fourth quarter of 2017 has drawn the outline of a head and shoulders topping pattern that is missing the right shoulder. A trade agreement or similarly positive catalyst could generate enough buying power to reach the broken 200-day EMA, now declining from $273, while a subsequent reversal would drop into the head and shoulders neckline, completing the long-term top.

However, the monthly stochastics oscillator still hasn't reached the oversold level in a bearish cycle that began in October (gray square). This could signal bearish price action well into the first quarter of 2019, lowering the odds for a January effect or news-driven recovery wave. In turn, the market could act like it did in the first few weeks of 2016, when the bottom dropped out in a vertical decline that continued into Jan. 20.

Traders should watch the 50% rally retracement level near $235 for a potentially tradable low in the coming weeks. That price zone has aligned with the 50-month and 200-week EMAs, which are deep support levels that finally ended the correction into 2016. The index hasn't traded below those moving averages in the past seven years, so this marks a last line of defense for battered bulls. On the flip side, it's important to remember that a breakdown through that support level in 2008 preceded a full-blown market crash by just three months.

The Bottom Line

The S&P 500 has sold off through the February 2018 low and dropped to a 15-month low. That leaves the Nasdaq 100 as the last domino standing in the uptrend that started in 2016. A sympathetic breakdown by the tech-heavy index could spike the Market Volatility Index (VIX) toward 50 while setting off a climactic selling event.

Disclosure: The author held no positions in aforementioned securities or their derivatives at the time of publication.

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