Resolution

10.5.2011

The eight-week trading range from early-August to late-September was finally breached the first two days of October. The move came to the downside, which was the most likely scenario. Our call for a very brief dip below the August 9th lows turned out to be correct. Last week we outlined a likely breach lasting several hours to no more than a few days – as it happened, the S&P500 remained below the August 9th low for a total of seven trading hours before a tremendous late-day rally on October 4th brought the index back above the August 9th low.

As the market has behaved just as expected, given the influences of current long-term and intermediate-term downtrends, clarity on the likely path of the market for the coming weeks and months has increased. There are four likely scenarios from here:

1. Market reverses down immediately, breaches the October 4th low, continues lower for a couple of days more, then rallies for several weeks to a month or two

2. Market rallies for several more days, perhaps a week or so, then retests the October 4th low

3. Market consolidates sideways for a few days, nears or retests the October 4th low, then rallies for several weeks to a month or two

4. Market continues to rally strongly off the October 4th low for several weeks to a month or two

We see Scenario 2 or 4 as most likely, Scenario 3 slightly less likely, and Scenario 1 as the outlier.

As the long-term downtrend that began on May 2nd remains intact, all rallies are likely to fail at some point. The key will be to determine when and where the failures are likely to occur. As the market continues to digest ongoing news flow regarding the economy, corporate earnings, and sovereign debt in the months ahead, the likelihood of a ‘surprising’ rally lasting several weeks to a month or two is now high. However, the rally is unlikely to breach the 2011 highs before failing and perhaps testing the October 4th low.

Markets tend to move relatively smoothly in long-term uptrends and choppily in long-term downtrends. This is due to the fact that downtrends trigger heightened emotional responses, which lead to markets overreacting to the downside, which leads to violent swings back upward. The very long-term tendency for money to generally flow into the equity market is another factor that creates choppiness during downtrends, as underlying long-term buyers do battle with cyclical sellers. We have seen this battle play out the past two months, and it will be ongoing for the foreseeable future.

In summary, there is a high likelihood that a multi-week rally has begun or will begin sometime in October. If the advance continues in a vertical fashion the next few days, there is a greater likelihood that the market will retest the October 4th low before any multi-week rally can occur. However, once the market does pivot into an intermediate-term uptrend, the rally may extend for a month or more thereafter.