Is the S&P 500 On the Verge of a Technical Breakdown?

Stock Market

The continuing weakness in the stock market is starting to cause concern. Technical analysts, in particular, are suggesting that if the S&P 500 ETF (NYSEARCA:SPY) falls any farther, it will trigger a steep correction. Other indexes are looking shaky too. The small-caps, represented by the iShares Russell 2000 ETF (NYSEARCA:IWM), are down nearly 9% from their recent high. The tech stocks, as measured by the Invesco QQQ ETF (NASDAQ:QQQ) have fallen from $191 to $177 since the start of May.

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So, what’s going on? Why are stocks looking so weak? And what sort of warning should we take from the technical indicators as the market’s slide continues? Here’s what you need to know about the S&P 500’s technical outlook heading into June.

The Technical Case for a Correction

There are a couple of key technical indicators that have lined up right here around the 2,800 level. The first of these is the S&P 500’s 200-day moving average. A dma is the average of closing prices over a set period of time. The 200 is widely watched, and is also used in conjunction with other dmas. When the 200 dma crosses the 50 dma to the downside, for example, it triggers a so-called “death cross”. More on that in a minute.

In any case, the 200 dma is a widely watched figure. Many technical and algorithmic traders sell once the market breaches the 200 dma. It currently sits at 2,776, and the market is less than 1% above that level as of this writing. Prior to now, the last time the market fell below the 200 dma was for just one trading day in March. Other than that, the market has steadily held above this indicator since early February.

There’s also the matter of support and resistance. Going back to last fall, the S&P 500 initially dropped from 2,900 to 2,700. It would subsequently bounce back to 2,800 on three separate occasions, but rally no farther. After the third failure at 2,800, the bottom dropped out in December, with the market falling 15% in the following weeks after the last test of the 2,800 level.

Also of note, once the market recovered this year, in March, the market stalled out at 2,800 again, setting off a mini-correction before stocks managed to continue climbing. As such, this 2,800 level is pivotal. There’s a ton of trading activity centered around this figure; the longer the market sits under 2,800, the more likely that support will bust and we’ll tumble to 2,700 or lower.

Should You Be Scared of A Death Cross?

A lot of technical traders also sell broad index investments, such as the SPY ETF, when the market makes a death cross. This is when the 50 dma falls below the 200 dma. It usually indicates that the market is losing momentum both on a short-term and longer-term basis. However, when the 50 dma falls under the 200 dma it shows that momentum in selling has picked up, often indicating a trend change.

Proponents of the death cross as a signal point to huge market wipeouts following death crosses. An investor that sold out of the stock market following a death cross would have gotten out of the market well before things truly collapsed in 1929, 1937 and 2008, among other big market plunges.

But that’s not the whole story. It’s natural that a signal that captures growing negative momentum would get you out of the way of many market crashes. However, it also turns up a ton of false positives. Market data tracker Oddstats on Twitter has a table of a complete list of death crosses dating back to 1924.

Looking on a case by case basis, you see that the death cross signal has preceded some huge market wipeouts. But more often, nothing much happens after a death cross. The median drawdown following a death cross is just 11% — a significant move, but not a disaster by any means. In general, death crosses often precede further declines, but the market tends to bounce back shortly thereafter. Again, using Oddstats data, the market traded 1%, 2% and 5% higher, on average, three, six and twelve months after a death cross.

Finally, it’s worth noting that we had a death cross near the beginning of December, with the S&P 500 at 2,700. Clearly, any short-term traders that sold on that signal were pleased. The S&P 500 proceeded to drop to 2,350. But the market bounced back to 2,700 by the beginning of February and subsequently went back to its old highs. In that case, investors that panic sold the market on the death cross gained little, though it worked as a short-term trading opportunity for the nimble.

S&P 500 and Stocks Outlook: What to do Now

It will be interesting to see how things play out for the SPY ETF and other major stock indexes in the coming weeks. Because, right now, there’s a huge divergence between the technical readings and the market’s fundamental outlook.

Fundamentally, earnings remain solid, GDP growth is strong, unemployment is near record lows, and the Fed has backed off its hawkish monetary policy. With plenty of fiscal spending, including a potential infrastructure bill in the works, stocks should have the green light. The trade war remains a concern, but that could end at any point. You have some other signs of weakness, like oil’s drop and slumps in emerging market stocks. But on the balance, the stock market should be rallying here.

Yet, one must respect the technical indicators as well. For short-term traders, if the market can’t hold 2,800, you might want to sell. As we saw in December, for example, the stock market can fall quickly once it hits a death cross. Don’t dump all your investments due to technical indicators though. There’s a great chance that in six months or a year, the SPY ETF and the broader stock market will be trading at nicely higher levels than they are today.

At the time of this writing, Ian Bezek did not hold a position in any of the aforementioned securities. You can reach him on Twitter at @irbezek.

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