Awful Week for Stocks May Be Just the Beginning

Last Updated Jan 17, 2010 4:41 PM EST

The plunge in share prices on Friday brought the decline in the Standard & Poor's 500-stock index to just over 4 percent for the week. There have been other big down days throughout the tremendous rally that began in March, but this one appears particularly portentous for several reasons and suggests that a serious correction has begun.

The explanations offered for major market moves are often lame and amount to ex-post facto excuses, and that was the case on Friday. An Associated Press story attributed the plunge to "grim signals about consumer spending," but they weren't all that grim and they were no worse than expected.

Personal income and spending in September were unchanged and down 0.5 percent, respectively - precisely what economists had forecast for each - and the University of Michigan consumer sentiment index was revised upward to a reading of 70.6, which is better than the consensus prediction.

Traders apparently took the reports in stride. Stock index futures rose after the income and spending data were announced before the open, and stocks reacted positively in the initial minutes after the sentiment figure came out.

The market looked decidedly bleaker later on, however, with no obvious catalyst to account for it. Prices fell in the last hour of trading, perpetuating a pattern in force every day this week, bar Thursday.

A rule of thumb on Wall Street is that dumb money - small investors and foreigners - is active in the first hour of trading, while smart money - professional traders, hedge fund managers and so on - set the market's direction in the last hour. Weakness heading into the close, therefore, is regarded as a harbinger of fresh declines.

Perhaps the grimmest development this week is the breaking of two significant uptrend lines in the S&P 500. Print out a chart of the index going back to early March and draw a line connecting the low that month with the lows of mid-July and early October. Now draw a second line connecting the lows of mid-August, early September and early October.

Two things are clear when you perform this exercise: The fit is pretty tight for each line, and if you extend each line out to the present, there is a clear move below it. Technical analysts call these violations of trend lines "breakouts."

This breakout means nothing - yet. The typical pattern is for prices to attempt to move back up, and through, a trend line. Sometimes it happens, but often the line that served as support becomes a line of resistance where selling intensifies, resulting before long in an accelerated move down.

These two trend lines are the sort that technicians love. They have produced clear bottoms for stocks for many weeks or months and, as a bonus, they converge in more or less the same place, around 1,050.

Watch what happens early next week. If the S&P pierces the trend lines and carries on higher, it suggests that the rally is still in force. But if it makes a stuttering move that stalls below 1,060 or so, traders may suddenly realize that it's a long way down.