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Examining a longer term chart of the S&P 500 confirms that we are still in a falling wedge pattern, despite recent gains. Should the rally give way here, many traders will begin selling in to the weakness.

We could see the S&P climb as high as 900 without fundamentally violating this pattern. Support areas are shown with horizontal lines on the right side.

Why have we witnessed four up days of trading that rocketed from the lows of 741 to nearly 890 on the S&P 500? Is it the start of a new bull market? This would be a very pleasant scenario, but bear market rallies can last days or sometimes even weeks and months. The most violent rallies, like those as of late, are generally short lived. The last time the market was up four days in a row was April, 2008.

How are bear market rallies possible?

Lately we’ve seen anything from government appointments to bail outs of multinational banks significantly lend to positive momentum. This is quite a contrast from the traditional inspiration of good earnings or economic data.

Bear market rallies are not created by investors buying to commit capital in to a stock for the long term, but instead by short covering and trading. The short term horizon of the participants and the lack of fundamental positive catalysts usually lends to these rallies collapsing to worse levels than they had climbed from, rather than a constructive bottom forming process.

When will we see the bottom?

A) The worst must be over: House prices are still dropping, unemployment is rising, consumer sentiment pushing all time lows and credit availability is tight. There is likely another leg down coming in both commercial mortgage backed securities and consumer credit card defaults.

B) There must be a positive catalyst within sight: Green energy has been promised to be the next bull market. Is there demand for these measures when oil is at $50 a barrel? The other question is, after committing half of last year’s GDP to financial bail out programs, how will the Federal Reserve and US Government continue to finance their spending? More importantly, will foreigners continue to lend to a less credit worthy nation?

C) The Federal Reserve must complete lowering rates and change to a neutral or tightening bias: The next Fed move will likely be another rate cut. To Bernanke’s Fed, deflation is still a bigger threat and he has the helo running full time dropping cash. Until this reactionary behavior is over, there is no sign that we are out of the woods.

D) Businesses must begin buying back shares: Many buyback programs have been halted, not accelerated. We have not seen corporations step back in and buy back their own shares. We also haven’t seen many insiders provide substantial equity commitments in their companies as of late. This is an important component of building a sustainable bottom.

E) Risk indicators must begin to show signs of significantly decreased aversion: The Japanese Yen, crude oil, one and three month T-bills (and lately even the long bonds) have all shown us that the flight to quality and away from risk (or growth) remains. The VIX is still above 50 and has major support at 45. Even gold prices are back above $800. Fear still seems to be a greater motivation than greed.

What are the charts saying?

The above S&P 500 chart is not confidence inspiring. The trend lines illustrate the wedge patterns and the horizontal lines show major resistance areas.  Currently the stock market is bumping in to major resistance. My indicators confirm this rally is overbought and due for a correction soon. 

Where are we heading next?

Based off the above analysis, I don’t feel this rally will get much above 900. Instead, we need to retest the intraday low of 741 on the S&P in the next few weeks.  There will probably be support areas on the way down at 875, 850, 830, 800 and 776. If the 741 low doesn’t hold, 600 is the next level of major chart support.

If you’ve made some money on the rally, don’t fall in love with the upside.  Remember that we still have a lot of problems to work through.  Folks with investments should use this as an opportunity to raise cash. If you’re looking to trade this rally, you may want to begin adding to short positions.  FinViz.com has some great tools for screening stocks if you use technical analysis to find your trades.  Good luck and stay safe!

Once again we find ourselves in the midst of a panic. After a long series of financial firms getting bailed out because of poor risk management and greed, now Citigroup prepares to receive tax payer funds in the amount of $100B or more. Pandit, Citigroup’s CEO, has been unable to restore confidence or restructure the international banking giant’s numerous units to restore stability, let alone profitability.

Even after numerous capital injections, receiving TARP funds and having access to all of the Federal Reserve programs, Citigroup is unable to stay afloat on its own.

There is a problem, though. Citigroup is incredibly interconnected. More than Lehman, AIG, Washington Mutual, Bear Stearns, etc. If they fail it could have a cataclysmic effect on the world financial system.

With Citigroup’s shares trading below $4 on Friday, the company is in dire trouble. Down over 90% from its high a year ago with no way to restore confidence. The stock plunge has created enough of a panic to break the 2002-2003 technical support level of 776 on the S&P 500.

Bailing out Citigroup will likely be more expensive than all the other bail outs combined. It is the fifth largest US bank and has over a trillion dollars in assets, many of which are defunct. Other firms have offered to step in, but only if the US government buys all the bad debt.

What’s next? Expect more business failures and the S&P to trade down to 600 and possibly 450. Those are the next major levels of chart support. This will be the worst recession the US has seen in at least 50 years.

The global equity markets hang in the balance now, with multiple key levels of support broken. Most recently the 2002-2003 recessionary lows of 776 as we closed at 757 on the S&P 500 today. Selling accelerated in to the close with the 776 level retested for the second time in the day and this time broken, after initially bouncing in to positive territory on a bounce from the first test that traders took the opportunity to short.

You may recall that almost a year ago I wrote about this possibility. Now we have confirmed the 10 year double top. The S&P 500 may now be poised to retest between 400-600 as the selling increases. There is some chance of a bear market rally first as the broadest US index is oversold by some measures. In either case, the world remains breathless as some of the worst selling in history destroys asset values across the board.

As the Federal Reserve, by funneling trillions out to banks in clandestine programs, attempts to boost the economy or at least stabilize the asset deflation mess that the real estate credit bubble left behind, we see a familiar concept once again emerging.  Reflation.

Reflation is when an economy is stimulated by central planners (Congress, Federal Reserve, etc.) through tax cuts or by increasing the money supply.

In this case reflation is being utilized to counter-balance the immense sums of money that are being destroyed.  Bear in mind that money is debt, and as the value of worthless assets contract, so does the current money supply.  The Fed, through its attempt to stimulate the next business cycle, has made money cheap again (1% if you can borrow from them).  At the same time, this non-governmental bank of banks has created numerous programs to temporarily or indefinitely purchase, with the promise of collateral, many troubled asset classes.

Why is this important to consider?  Because if you hold US dollars (also known as Federal Reserve notes), you will eventually pay for this mess.  You will pay through what later could prove to be a massive inflationary currency crash when reality catches up to the dollar once global economies begin raw material consumption again.  Reflation is a dangerous game to play because no one can possibly understand how much or how little is necessary to find the perfect balance.

 "Central planning an economy"

Central bankers use computerized models based on algorithms, flow charts and other techniques to determine what possible outcomes there are from many scenarios.  The problem is that our economy does not exist inside their simulation program, with its greatly limited capacity to estimate the potentially chaotic nature of relatively free markets.  Our economy exists in the hearts and minds of humans who command billions of computers.

The disastrous consequences of central bankers planning economies can be seen both with the Dot Com bubble (and bust) as well as the real estate bubble and the meltdown our economy is once again experiencing.  These bubbly boom-bust cycles are all too familiar for those who have experienced the “Greenspan put” of the past two decades.  Under all circumstances former Federal Reserve chairman Alan Greenspan would support the stock market instead of the currency’s purchasing power, creating the illusion of prosperity built on a hidden tax of the American public called inflation.

The days of such blissful ignorance may be drawing to a close, however, as reflation’s capability to generate a bigger bubble than real estate is unlikely.  America can no longer trust in the idea of borrowing against future earnings or investing in the markets for enhancing wealth.   It’s no coincidence that borrowing-based consumerism/corporatism as well as buying and holding stocks have become philosophical dinosaurs at the same moment in history.  Neither practice is rational in an environment where the riches amounted to little more than a modern financial house of cards.

With a week full of potentially sour economic data and political uncertainty, the market may be poised to resume its downtrend and give back much of its gains.  See our chart of the S&P December 2008 futures:

The chart above shows the potential for the downtrend to resume as the futures have considerably weakened off their overnight rally, which retested Friday’s highs.  We have had a week of mostly gains, with back to back up days.  In this kind of bear market environment it is doubtful that the rally can last too much longer.