The historical importance of the current enviornment on the main U.S. indices cannot be underestimated. The best economists, analysts and experts are struggling over the question: has the bear market of the past year ended, or has it just started and we are on the verge of one of the largest market crashes in history? The enviornment is so ambiguous that there are multiple different scenarios being discussed by experts.
I did my own research, having thoroughly studied several dozen different macroeconomic and technical indicators on major indexes, sectors, large stocks and other instruments, and came to very curious conclusions, which I will try to set out in detail.
Over the past two years, I have been working on creating an analytical forecast model that determines medium-term reversal levels for key U.S. indexes and stocks. This model is based on comprehensive comparative research, which includes fundamental and technical analysis with identification of repetitive patterns for a bunch of technical indicators showing extreme overbought/oversold zones, the relationships between them, as well as direct and reverse correlations, convergences and divergences over a large historical interval. To confirm a trend pivot, I also used Elliott Wave analysis, Fibonacci levels and trading indicators such as the relative strength index, moving averages, Bollinger bands, the McClellan oscillator, technical patterns, channels, price levels, volumes and other tools.
Based on these models, I managed to identify unique relationships and patterns showing a high probability of determining a potential trend reversal, as well as accurately calculating all major pivot levels in the current bear cycle. I will present the main conclusions and demonstrate some key patterns in order to try to predict what may await the U.S. stock market in the near future.
I am not going to focus much on macroeconomics since a lot of extensive research has been done by many renowned economists. I will only note the main factors that continue to affect markets. It is quite obvious the cycle of monetary tightening and high rates will inevitably lead the economy to a recession. A number of advanced macroeconomic indicators, such as an inverted yield curve, inflation, the Purchasing Managers’ Index, Consumer Confidence Index, University of Michigan Consumer Sentiment Index, retail sales and others have long signaled an impending recession.
To combat high inflation, the Federal Reserve has switched to a policy of quantitative tightening by hiking interest rates and absorbing liquidity from the market. In order to overcome inflation, it has to significantly suppress the level of consumer consumption, which will inevitably provoke unemployment growth and eventually lead to a recession. This is a vital process for the economy, which must shed the dead weight of unprofitable zombie companies and reset the economic system in order to restart the cycle of healthy growth. The only question that remains is whether the recession will lead to a soft or hard landing. For the purpose of this study, it is important to know that historically, the major market crashes occur during Fed rate cuts as a result of the high rates' impact on the economy. On the contrary, during Fed pauses, markets tend to rise. The last growth looks like a bear rally, not a trend change. Assuming that in the near future the central bank will suspend further rate hikes, the stock market can expect a significant rally within a few months, after which, according to this logic, a powerful crash should follow.
Now let's try to understand from a technical point of view what is happening and what can be expected in the next few months. Since the beginning of the bear market, the main U.S. indexes have formed an expanding descending diagonal, and most analysts were inclined to believe that within this diagonal there would be another decline to the 3,000 to 3,400 points area for the S&P 500. In the light of the latest growth, the diagonal scenario has been questioned. For example, the Dow Jones Industrial Average broke through the diagonal back in November, having won back 75% of the entire correction in just two months. At the end of January, we witnessed the price break out of the 200-day moving average on the daily timeframe and a break of the diagonal on the S&P 500, which also cast doubt on the continuation of the bearish scenario. Moreover, a golden cross has been formed on the chart, when on the daily timeframe (50-day moving average) crosses MA200 from bottom to top. Historically, this almost always meant a change in trend and the index went to conquer new peaks. In any case, this applies to all bear markets and even almost all intracyclic corrections were subject to this rule. Also on the weekly timeframe, the price broke through MA50. But let's not jump to conclusions. Keeping in mind that a recession is coming and a change in the Fed's rhetoric is not far off, it is necessary to take into account many other equally important factors to build the most likely scenario.
Let's start with a comparative analysis of the interaction between price and moving averages. Although I did this research at the end of January, just before the breakout of the MA200 on the daily chart, I never believed this was the start of a new bull market.
Many optimists assume the breakdown of the diagonal and MA200, as well as the formation of a golden cross, confirms the global trend change. While this may sound very convincing, if we look back in history, we can find similar price action during a few bear markets.
For example, a similar technical pattern occurred in October 1973, when the price broke through MA50 on the weekly and MA200 on the daily timeframe. What happened next is well known: the index collapsed and lost another 45% during the year (see chart below on the left). Another similar pattern occurred during the 2002 dot-com bubble burst, when the price broke the MA200 twice, followed by a 34% drop (chart below on the right).
A resemblance to the current market environment was also observed in 2008. There are two bear markets in the charts below: 2008 and now. The following indicators are illustrated from top to bottom on the weekly timeframe: RSI, S&P 500 Index (black curve on the chart - MA200, blue - MA50), stocks above 200MA, stocks above 50MA and MACD.
It is clearly seen that on both charts the price rebounded to MA50 after testing MA200. At the same time, RSI is slightly above 50, while MACD is still in the negative zone with a bullish divergence. What happened next in 2008 is also clearly visible - the index crashed by 53% in less than 10 months.
The top right chart shows a possible schematic scenario if the bear market continues. I should warn you against prejudiced opinions based solely on similarities to past scenarios. This does not necessarily mean the 2008 or 1973 scenarios will inevitably work out. The purpose of the current research is to show that regardless of how bullish the latest rally might seem, it can finally end up with a continuation of the bear market with perhaps an even larger market crash ahead.
Special attention should be paid to the volatility index and its inverse correlation with indices. I analyzed the history of this correlation over the past 20 years and revealed a surprisingly accurate pattern, which is illustrated in the chart below.
Every time the stocks above 50MA reach extremes (S5FI, orange curve), the VIX bottoms. It also coincides with a bottom of RSI and MACD. At the same time, after bottoming out, the VIX tests MA50 from below (blue curve on the chart), then pulls back slightly, forming a divergence with stocks above 50MA and soars by 70% to 100% or more within a few weeks. I have double-checked this pattern throughout the historical period since 2007 - it works perfectly.
On top of that, we are now witnessing an even more unique picture on the VIX that has only happened twice in history - just before the major crash wave of the dot-com bubble and the 2008 crash (see charts below).
In all three cases, you can see a very similar flat with almost the same values at the top and bottom along with an uptrend line on the lows serving as a support zone. At the same time, there is a surprisingly similar divergence on RSI, MACD and shares above 50MA. This implies a high probability of a significant rise of VIX in the very near future. And this always happens when indexes accelerate their fall and rush to a new bottom.
A number of bear indicators also reached extremes, such as the Fear & Greed Index, Intermediate Term Optimism Index, S5TW (stocks above 20MA), divergence on McClellan oscillator and MACD, divergence between smart money and dumb money and others.
In summary, I believe the bear market is far from over and we will soon see another huge wave of decline with potential bottoming at around 3,000 to 3,200 points by the S&P 500. In the short term, this does not exclude the possibility for the indexes to go a bit higher as a rebound or another leg of corrective growth.
