'tis the season for a bottom, but buyer beware!

Kevin Pendley | Oct 25, 2008 6:08pm EDT | Comment

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I’m going to take a stab at doing something I truly detest – I’ll ponder, however briefly – some of the elements that are coming into play that suggest we are rapidly approaching an area where downside risk is outweighed by upside potential.

Loyal readers of this column will remember back in March I wrote a piece that examined stock market declines in recessionary frames dating back more than 30 years. The basic equity collapse during recessions tends to wind up in the 50% zone (for reference, small-caps tumbled 47% in the 2000-2001 bear market recession). At Friday’s low, the Russell 2000 (NYSE:IWM) was down 46% and a rounded off 50% recession target is at 430, or about 8.5% below current values. I realize 430 seems cruel after what we’ve already endured, but as you’ll see below there are legitimate chart formations in play that also carry a target down to 415. But if this recession collapse starts to peter out in the 50% zone, then at 450 or so the temptation to consider low-risk buy-side market approaches makes some sense – at least mathematically.

OK, so we’re fast approaching historical recession bear market norms and the market is dramatically oversold, but another tantalizing detail comes from a seasonal standpoint. Simply put, October is a great month for the market to stage major bottoms. We have seen key small-cap lows forged in the month of October in 2005, in 2002, in 1999, in 1998, in 1992 and in 1990. And in 2001, the low was set in late September. So there you have it: the seasonal is favorable, the market is ripe for a bounce given overdone momentum readings and the declines are approaching our recession targets.

Taking a stab at picking the bottom on this collapse has become a non-stop cottage industry on financial television and among market pundits, so why do I hate some of these exercises that revolve around picking a market bottom? At heart, I’m a pattern guy. I trust the historical reliability of strong reversal formations. I believe in trends. There is a very real reason they say that trying to pick a bottom in a panic slide is akin to trying to catch a falling sword with bare hands – more often than not, you’ll get sliced up for the effort. And the big problem with trying to pick a bottom on this current stock market collapse is that there are no powerful reversal patterns to hang your hat on right now. If fact, the dominant chart formations retain a decidedly bearish tilt.

The velocity and magnitude of the collapse border on unprecedented. Just take a peek at the monthly chart and the red candle for this October is jaw-dropping. There is a new theory making the rounds that when this market bottoms, the recovery move will be every bit as stunning as the collapse was on the way down. I’m not so sure of that prediction, but we can examine the possible route in a future column, hopefully in conjunction with a discussion of an actual powerful reversal pattern in play on weekly or monthly studies. I’m just like everyone else in agony watching this market chew up my 401k – I’d love to see things turn around to the upside, but until we see a commanding pattern to back up a bottoming call, it’s nothing more than hopeful speculation and a very risky way to approach investing.

Price action last week was an absolute back breaker for the bulls. The market continues to dangle capitulation sell-off/intraday rally recovery moves that generate short-term enthusiasm only to be dashed quickly. Unfortunately, those intraday recovery rallies off the lows never did correlate with a decent weekly reversal formation, and even on daily charts the most reliable pattern last week was a downside breakout of a pennant pattern. As long as the Russell holds below 500, the target move on this breakout comes in down at 415.

Looking at this week’s action, there will be support at 458, which represents a 75% retracement of the entire 2002-2007 bull market run. From there, support should be seen approaching 450, then there is a big vacuum down toward our recession target near 430. Persistent price action this week below 500 would suggest that we are building a new lower range for the Russell, which would be a troubling sign. If the market can mount a decisive push back above 500, then 525 and 546 become the upside tests that matter.

The table below contains support and resistance points for the Russell 2000 to keep in mind heading into this week’s trading. For long-term traders, some of these key levels may remain in place for weeks...even months at a time. Those with a short-term horizon will lean toward levels that are more immediately in play. As time passes, we will build upon this table with levels that come into focus as important testing zones for trend analysis, and to act as road mark indicators for key reversal patterns.

From a trading perspective, I always keep a printout handy each day of my key support and resistance points for any stock or market I’m trading. It helps remind me of key areas to watch for signs of trend exhaustion, and also for potential entry/exit points for trades. Keep in mind that when the market is near record highs, it is much easier to find valid support than resistance points.

TECHNICAL ANALYSIS SUPPORT/RESISTANCE POINTS FOR RUSSELL 2000

- 890.16   upward channel resistance on monthly charts off 5-year run;
            also fits with potential upside breakout of congestion zone
- 860.00   projected “figure” resistance off 15-handle testing zones on the ’06 rally
- 856.48   record intraday high set July 13, 2007
- 855.77   July 13, 2007 close; record high daily and weekly close
- 852.06   Oct. 11, 2007 high; bearish reversal peak on daily charts
- 830.01   previous high from the February 2007 peak; key swing line of note
- 815.00   key swing line
- 801.00   congestion resistance zone from November-December 2006
- 775.03   61.8% Fibonacci retracement of the Aug. 2007 peak-Mar. 2008 collapse
- 764.38   new move high set August 15, 2008; approximate double top with June ‘08
- 762.89   previous move high set June 5, 2008
- 760.06   March correction low; key approximate double bottom formation support;
            Near 50% Fibonacci of July ’06-’07 bull run; violated in November ’07;
            Key swingline to watch
- 743.49   previous Aug. ‘07 collapse low; short-term support violated, now resistance;
            Also near chart gap left by Jan. 2008 employment report news
- 726.19   previous double top in June/July 2008
- 720.50   recent trading range swing point
- 700.00   “figure” swing line; no monthly close below here since Dec ’05 until Feb ‘08
- 685.00   20% decline off 2007 record highs; breached Jan. 2008, July 2008, Sept. ‘08
- 680.94   mild reversal low on daily charts Jan. 28; near 50% of the March ’08 bounce
- 668.58   July 2006 low; important bottom for summer correction; now resistance
- 667.86   20-week moving average; nice trend support for bull run; smashed on
            July/August 2007 collapse
- 660.00   short-term downside target on wedge breakout; now swing line
- 650.00   previous bear market move low set Jan. 22, 2008, former critical support zone
- 647.37   July 15 2008 low; approximate triple bottom with Jan ’08; Mar ’08; snapped
            October 2008
- 643.28   previous move low set Mar. 10, 2008; now resistance
- 614.76   October 2005 bottom; next major chart related downside point
- 606.42   April 2004 highs, now long-term support
- 591.00   50% Fibonacci retracement of the 2002-2007 bull market run
- 577.00   consolidation zone when marketing was bottoming in spring 2005
- 570.06   absolute low on spring 2005 bottom
- 561.02   20-day moving average
- 546.00   short-term resistance from daily charts in October 2008
- 515.00   mild resistance on a bounce
- 500.00   logical big “figure” swingline
> 471.12   Oct. 24 close
- 461.60   move low forged Oct. 24, 2008
- 458.00   approximate 75% retracement of entire bull market run
- 430.00   figure point near 50% “recession target” pullback
- 415.00   pennant breakout target
- 400.00   figure support matches with trading zone from 2002-2003

In addition to the printout of support and resistance points to watch, I also like to keep in mind where sudden volatility can spring into the trading mix from the typical release of economic data and Federal Reserve activity.

The economic calendar picks up steam this week, serving up key data on home sales, GDP and consumer confidence. However, the likely highlight of the week should be the FOMC announcement on rates Wednesday, and the statement that comes out with the rate cut news. Although there is no doubt among market watchers that the Fed will cut rates, there is a big difference of opinion about whether the cut will be 25 or 50 basis points. There is also an appearance Friday afternoon by Fed Chair Bernanke that could stir some volatility into the market at the end of the week’s trading.

The table below highlights calendar event risk for the week, with the emphasis on various economic reports. Our table below has a special “Risk Factor” designation, which is simply my assignment of risk to that event, ranging from 0 to 5, with 5 marking the highest risk for volatile market swings.

CALENDAR EVENT RISK ASSESSMENT

RISK FACTOR REPORT/ITEM (all times ET) Consensus

3           New Home Sales (Mon., 10:00 a.m.)                   -2.2%/455,000
1           Former Fed Chair Volcker on economy (Tues., 8:00 a.m.)
2           Case Shiller Home Price Index (Tues., 9:00 a.m.)     -16.6%
4           Consumer Confidence (Tues., 10:00 a.m.)              52.0
1           Richmond Fed Survey (Tues., 10:00 a.m.)             -22
1           Treasury’s Paulson speaks (Tues., 10:00 a.m.)
2           Durable Goods (Wed., 8:30 a.m.)                        -1.1%
5           FOMC Rate Announcement (Wed., 2:15 p.m.)        1.00%
5           GDP (Thurs., 8:30 a.m.)                                    -0.5%
3           Weekly Claims (Thurs., 8:30 a.m.)                      475,000
0           Fed’s Kroszner on risk management (8:30 a.m.)
1           Fed’s Yellen on econ, mortgages (3:15 p.m.)
1           Personal Income (Fri., 8:30 a.m.)                         +0.1%
2           ECI (Fri., 8:30 a.m.)                                         +0.7%
3           Chicago PMI (Fri., 9:45 a.m.)                               48.3
3           Michigan Sentiment (Fri., 10:00 a.m.)                    58.0
4?          Fed’s Bernanke on mortgage, econ (Fri., 2:00 p.m.)