Stock Markets Setting Up To Break Out Of Funk?

The S&P 500 opened Friday morning by violating last November's intraday low of 741.

That's not good news for investors. We couldn't be in a more precarious situation.

Still, history indicates that now might be the time when real money can be made in stocks. How so? The risks are relatively low at this point since we're closer to the market's bottom than when the market was at its peak in October 2007.

At that time, the S&P 500 was 113% higher than we are today. That's a tough concept for most people to wrap their heads around. But it's at times like these when the reward-to-risk ratio is the greatest.

At this stage of the current downtrend in stocks, some key technical factors now indicate that exchange-traded funds investors have reason for optimism over the next several months.

First, let's look at market sentiment. According to the American Association of Individual Investors, when the mood of investors moves above 55% bearish and below 25% bullish, readings at those levels show an uncanny track record of signaling market bottoms.

Where we are today is: 56.7% bearish and 21.7% bullish (by the AAII's tracking).

These are historically extreme levels. And a survey of headlines in the media supports such sentiment tracking. The overwhelming majority of articles seem to be taking negative outlooks. Just look at IndexUniverse.com's front page. One article screams: "Great Depression Ahead?" Although the story by Allan Roth makes a case for not overreacting, it still points to the high level of headline risk at the moment that stock ETF investors face.

You'll be hard-pressed to find many people taking a bullish view in the face of the overwhelming tide against the markets. But keep this in mind—sentiment is a contrarian indicator. The masses are never right. Let me repeat that—the masses are NEVER right.

Another technical indicator that should cause reason for optimism is that the number of stocks hitting new lows on Oct. 10, 2008, was a little more than 3,000. By comparison, on Nov. 21, 2008 (the market's second major low in this current cycle), only 1,500 names hit new lows. And yesterday, there were only 400 stocks hitting new 52-week lows.

This demonstrates that the breadth in selling pressure is being reduced. If you look at the 10 major sectors making up the S&P 500, while all are in downtrends, only three are trading below last year's lowest points. Those sectors are Consumer Staples, Financials and Industrials.

The seven other major S&P 500 sectors are still above their lowest levels of 2008.

So while stocks are sinking further, their fall is quite constrained. It's important to note that big falls in only a few sectors—demonstrated by popular ETFs tracking those segments—are dragging the rest of the market down. In particular, look at the Financial Select Sector SPDR (NYSE: XLF), which trades roughly 182 million shares a day; the Consumer Staples Select Sector SPDR (NYSE: XLP), which trades about 6.5 million shares per day; and the Industrial Select Sector SPDR (NYSE: XLI), which trades some 11.1 million shares a day.

Another factor that technicians consider is something called the high-low index. That takes the percentage of stocks hitting new 52-week highs versus the total number of stocks hitting highs and 52-week lows. Right now, that index shows that as of Thursday, some 2% of all U.S. stocks that are hitting either their high or lows are reaching the high end of those ranges.

Technically, anything under 20% demonstrates oversold conditions. So we're at extremely oversold levels at this point.

It appears both the S&P 500 and the Nasdaq-100 are undergoing a double-bottom formation. That's a very strong technical indictor of impending sharp upturns in the market. For example, take the SPDR S&P 500 ETF (NYSE: SPY). It hit an intraday low of $74.34 per share on Nov. 21, 2008. This morning, we've breached that low.

A double-bottom formation, if it holds up, eventually looks like a "W" on a price chart. That's a technically strong reversal pattern. And again, it's forming in SPY and the Dow Diamonds (NYSE: DIA) right now.

The market has climbed a wall of worry. But we're entering into a possible period of strength next week. New contributions to 401(k) retirement plans will start filtering into the market starting on Monday, the first business day of March. This could act as a catalyst and it could influence other investors, igniting a move up in markets sometime during the week.

Another key technical indicator is the 200-day moving average. SPY is 31% below that average and DIA is 29% below its 200-day moving average. Historically, those are very wide spread levels from their averages. Eventually, a reversion to the mean should occur with each of these ETFs.

The ideal situation is that Friday ends lower and investors sell off in a panic-driven washout on Monday. That would shake out the nervous Nellies and we could have a 25-30% rally between now and the end of spring.

But let's not get ahead of ourselves. Whether any coming rally—which markets seem to be technically setting up for—lasts is still questionable. After all, fundamentally, stock markets are basically pretty well shot. So you might consider using stop losses with any stock ETF purchases to limit downside risks in this environment. A fairly routine level would be 8-10% below the purchase price to mitigate losses and maximize returns.

Jerry Slusiewicz is president of Pacific Financial Planners in Newport Beach, Calif. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it