Some three months ago the S&P 500 broke out above 965 from a massive year-long bottoming formation, heralding further gains. But after following through to the upside by a relatively scant 50 points, the market has since languished in a narrow consolidation area. Astute technicians know that follow-through is a very important factor in establishing the validity of any breakout. A lack of follow-through makes any breakout suspect.

The significance of the breakout in the S&P 500 suggested that the market should have continued moving sharply higher. Said another way, we'd expect a wildly bullish event to engender a wildly bullish response, But as I've often admonished readers of The Sovereign Strategist, when what should happen fails to occur, the opposite becomes increasingly likely. When a relatively high probability event fails to materialize it indicates an inherent weakness that makes a contrary event more likely.

Time yields the next clue to the market's underlying weakness. The S&P 500 has spent nearly 2-1/2 months drifting aimlessly sideways. In comparison, the rally that began in mid-March ran for 3 months. In a powerful bull trend we would expect the market to spend more time rallying in its early stages than drifting sideways, particularly in the wake of a very important breakout. Certainly this isn't always the case, but the longer the market drifts without posting new highs, the more suspect the preceding rally becomes.

Other warning signs have flashed. While the Dow and the Nasdaq recently posted new highs, the S&P 500 failed to confirm. A broad market measure like the S&P 500 lagging the other indices can be construed as a bearish divergence if the condition persists. (The Wilshire 5000 has also had some trouble extending its uptrend.) Not to mention that those new highs were swiftly rejected with all the indices closing sharply lower on 8/22/03 resulting in what technical analysts refer to as "reversal" sessions. Reversal sessions tend to portend counter-trend moves.

Further bearish indications appear in the financial stocks. Take a gander at the charts of Merrill Lynch (MER), Citigroup (C) and JP Morgan (JPM), Bank of New York (BK), Goldman Sachs (GS), Morgan Stanley (MWD), Charles Schwab (SCH) and smaller firms like E*Trade (ET) and Tradestation (TRAD).

All of their chart patterns exhibit highly significant potential topping formations: head & shoulders, double and triple tops. To put it very simply, these patterns represent a condition in which buying pressure is no longer sufficient to push the stock to a new high, the market falters, and prices fall through a previous low indicating that sellers are now in control.

In most of our examples, the topping patterns have not yet been confirmed, (by a decline through a previous low), but all are developing so clearly that it's hard to imagine their failing. And trouble for the financial stocks often spells trouble for the rest of the market.

Technicals aren't the only stone under which trouble lurks. From a fundamental perspective, the bond market has careened lower, sending interest surging higher at a nearly unprecedented pace and magnitude. Not good for a nascent economic recovery nor an emerging equity bull market.

Nonetheless, market fundamentalists argue that after a highly accommodative thirteen Fed rate cuts stocks are in excellent position to climb. But we feel that the market should be more concerned that after thirteen rate cuts, only a small portion of the bear's damage has been reversed. Only a couple of years ago the pundits argued that the stock market always rallies after three rate cuts. When thirteen fail to do much, we have to wonder what's wrong with the underlying structure of the market.

Yet another danger sign is being flashed by the gold market. Gold is on the verge of posting multi-year highs while many gold stocks already have. Serving as a barometer of the underlying health of our economic system, a powerful upmove in the yellow metal is a strong indication that the underlying financial situation is not quite as sound as it appears.

Do all these warnings spell a definitive end to the uptrend? Of course not. Regardless of the outlook, our policy is never to argue with the market. We remain alert and poised for a substantial downdraft, but ultimately the S&P 500 will tip its hand by breaking out of the current trading range between 961 and 1015. On an upside breakout we expect our objective of 1150 to be fulfilled while a breakdown below 961 should offer an opportunity for substantial gains on the short side of the market. Bullish or bearish, there's always a profit to be made!

Mark M. Rostenko
Editor
The Sovereign Strategist

August 30, 2003

Mark M. Rostenko, a veteran of Chicago's commodity exchanges and editor of The Sovereign Strategist, spends far too much of his time enthralled by the never-ending procession of inane prattle emanating from Wall Street. Nonetheless, it hasn't stood in the way of accurately forecasting the dollar's top, the beginning of the gold bull market, and nearly every significant turning point in the stock market since the bear market began. Please visit www.sovereignstrategist.com for a free sample issue and more commentary. And while you're there, feel free to join our international family of well-informed and successful investors.