Yes, there will be a rally again and maybe even soon, but it is what happens AFTER this rally that determines whether a top is already in place or whether we will actually make new highs. Those proclaiming certainty at this stage must have access to information that I don’t have perhaps, but my take is that the jury is still out. As most of our readers know I have been, and continue to be, structurally bearish due to excessive central bank policies and lack of organic growth (see also the Big Bad Bear Case). However, we’re currently bullish from a trading perspective and I’ve talked a bit about this in Reading the Tape.

This puts us in a bit of a contrarian camp at the moment as there’s a lot of bearishness out there and talk of a bear market and it is true the price action has been bearish and a lot of damage has been done. Yet let me walk you through some key charts that point to a coming rally and demonstrate why it is what happens AFTER this rally that will determine whether we will see a real bear market or a resumption of a massive blow-off top rally.

Firstly note on a definitional and structural basis we are NOT in a bear market yet. The $SPX has not corrected 20% or more and key weekly moving averages are still moving north.

If you examine the chart below closely you can see that the recent corrective move below the weekly 100MA and even 125 MA is a rare and sizable corrective event, but with plenty of historic precedent:

Several things to note:

Firstly a general observation: The lows in 1998, 2002, 2009 and 2011 all had one common element: A lower price retest with a positive RSI divergence. In all of these cases these retest lows came within a 1-3 month period after the initial low. This suggests that if we are to make a successful long term low another retest is in the offing at some point this year.

Let’s look at the specific weekly 100MA/125MA reference examples:

1. In 1998 we saw a bottom after a retest with a positive RSI divergence. Markets went on to new highs into 2000. Note the weekly moving averages were moving NORTH during this correction and the weekly 50MA was recaptured on the resumption of price trend.
2. After the 2000 top the initial break of the MAs resulted in the counter rally that tagged the weekly 50MA before falling to new lows. It is THEN that the moving averages crossed south and a bear market was confirmed.
3. In 2008 we had an exact repeat of the 2000 scenario. Retag of the weekly 50MA after initial break and then cross-over of MAs.
4. In 2011 we basically saw a mix of the previous scenarios but with a positive resolution. Tag of the weekly 50MA, rejection, and then resumption of price trend with MAs remaining northward oriented

Which brings us to the here and now: The moving averages are still pointing north, although the weekly 50MA looks to be ready to turn. But we do not have a negative cross yet. Far from it and hence the historical track record suggests a bounce toward the weekly 50MA at some stage. Whether this comes after a retest in price or before is unclear, but it’s coming.

If indeed this is a bear market to unfold then nobody should be surprised by an aggressive rally to come. Nothing is more vicious than a bear market rally after all.

Also, as the historical record shows, it is what happens after the weekly 50MA tag that determines everything. Will the weekly MAs turn south?

The bear case is actually pretty straight forward from a price perspective. Let me walk you through it:

A key trend line has been broken on the $ES. A rally into the weekly 50MA would likely also produce a retest of the broken trend line. This retest also coincides with major overhead resistance:

This could structurally set up for a massive heads and shoulders pattern and a subsequent break below the neckline would produce a measured move into the 1538 zone which coincides with major support.

Why is this level major support? Two reasons, it matches the previous highs of 2000 and 2007 and would also coincide with a 38.2% Fib retrace of the 2009 rally:

So technically and structurally this is pretty straight forward and makes sense.

What’s the case for new highs and resumption of trend a la 1998 instead? This case too actually has merit.

For one M1 money supply is still at the highs and since 2009 there has been no case where M1 has lost the battle:

So we can currently observe a massive divergence between price and M1 money supply. Explaining this divergence is the massive exodus we have witnessed with people dumping stocks. And it is this drastic exodus that may seed the next big rally. Just looking at money flows outlines the risk/reward equation:

The MFI alone highlights the likelihood of an imminent rally to come. From my perspective it also supports the notion of a rally into the weekly 50MA.

But the when is the unknown factor and hence trading this volatile action requires utmost flexibility. Trading volatile markets can be extremely difficult as price can fluctuate wildly and unpredictably. This past week has been no exception. The way we’ve been trading it is holding scaled down swing low positions (meaning we already locked in profits on them, have flat stops on the rest, but letting them run long) which we caught near the lows and day trading additional positions during the week taking advantage of the intermittent volatile price expansion by buying weakness and locking in profits on the rips. This has worked really well and continues to be our primary strategy here.

Nobody knows what the Fed will do in September (may trigger the retest?), or what China will do to stabilize its markets, Mario Draghi indicated additional QE coming in Europe if things get worse (I’m reading between the lines), so we know the central banks are watching and are actively engaged to prevent disaster. I doubt they will just roll over and watch their construct fall apart. Whether they can retain control however remains the big unknown risk factor in these markets.

What we do know is that key charts indicate that for the here and now pressing short is getting increasingly dangerous:

In fact, there is one chart that tells me a rally may come sooner than most think. Last week we had some pretty nasty downside action, yet the high/lows remained oddly relatively flat:

and a key trend line held yet again:

This tells me selling pressure may potentially be ebbing for now. So our strategy remains the same at the moment: Riding swing longs with flat stops, buying weakness, locking in profits on strength, rinse and repeat.

Price now is in a 300 handle range on the $SPX offering plenty of playground time for flexible traders while bulls and bears have to prove their cases. Traders don’t design the playground, but we sure can play on it 🙂

There are a lot of moving parts here and nobody can know how this will play out in the end, but these charts above give us historical context and can help assess risk versus reward. And, more importantly, they tell us to keep an open mind here still as to the next big move.

Good luck in the weeks to come.