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Assuming this pattern continues, it looks like the rally from the March, 2009 lows is over and we have entered a bear market phase. In order for this to change, the market would have to stage a strong rally pushing the MACD above the upper downtrend line. Based upon the current macro economic environment the chances of that happening seem unlikely.

The MACD peak also corresponds to a period of global uncertainty. With European economies on the edge, France and Germany have made it clear that they are not going to immediately back stop the Eurozone. According to the Fed, the U.S. economy is going through a protracted weak period although certain recent economic data suggests that some areas of the economy may be improving.

As I indicated in my entry of June 21 a possible head and shoulders pattern was forming on the S&P 500. Then in my entry of July 14 I indicated that an inverse head and shoulders pattern appeared to be forming in the near term. We can now conclusively say that the inverse head and shoulders pattern has been negated and there are fully formed head and shoulders patterns sitting on the S&P and DOW.

Just because a head and shoulders pattern has formed on the major averages does not mean the market is going to drop further as a reversal off the neckline is bullish. In order to find out where the market may be headed at least in the short term we will look at various charts and technical indicators.

The S&P has dropped slightly below it’s 50 day EMA and is sitting right at the neckline of the H&S pattern. RSI at the top of the screen is in a downtrend and has not hit the bottom of the channel nor is it at oversold levels. The MACD looks like it may be turning up near the 0 level. The bottom indicator is Williams %R, an indicator that uses momentum to measure overbought/oversold levels. Readings below 80 indicate oversold levels. Right now it is reading 99.99 a condition that is extremely oversold. The last time it hit this level was in March, 2009 just prior to the start of the bull market. Also each time it has dropped below 80 since March, 2009 it has indicated a near term market bottom and quickly reversed upward.

If we take a look at the DOW the picture is almost identical except it hasn’t quite hit it’s 50 day EMA.

The U.S. dollar has formed an uptrend channel. There is a downtrend line from the May, 2010 top that was briefly broken through in July but the dollar retreated to the bottom of the channel. That downtrend line now coincides with the 20 day EMA which has acted as near term resistance.

Gold has been on a rampage but appears to have hit an intermediary top. A look at the chart shows that it has rallied right to the top of a huge ascending wedge pattern. A breakthrough of the top line would be incredibly bullish but this line should act as strong resistance. The RSI is in overbought terrritory as is Williams %R. Each time the RSI has moved into overbought levels it has tended to either quickly pull back or consolidate for awhile. (Note: In after hours trading gold has traded above the upper trend line. It remains to be seen if this will turn into a confirmed breakout.)

Conclusion: From a technical perspective the markets appear to be at a reversal point. I would expect a bounce in stocks and a pullback in gold. The current economic outlook appears to be deteriorating but the market looks like it has already factored that in.

The bull market since March, 2009 has been earnings driven. If earnings start to trail off then the market will correct for that. The U.S. dollar is in the dumps and there no longer seems to be a direct correlation between a weakening dollar and a rising stock market. Gold and bonds are acting as the risk off trade as opposed to the dollar. If the dollar can manage to rally it might be good for stocks as it would indicate that the U.S. economy is experiencing a sustainable recovery but the fundamentals do not appear to confirm that view. There is always the possibility of a QE3 which would put even more pressure on the dollar and further inflate the price of gold and other commodities.

We know that we are in a secular bear market due to the worldwide macro economic conditions that have developed and the massive market sell off that was fear and panic driven. Between the S&P low of Nov. 21, 2008 and the lower low made on March 6, 2009 the macd moved higher. This is a positive divergence that indicates the market will rally. The vix hit a double top of 81 on Nov. 21 and then a much lower reading of about 50 on March 6. This indicates that we have hit an intermediate to long term bottom at these levels.

There are 3 major downtrend lines that define the bear market. The major downtrend line connects the Oct. 8, 2007 high to the May 19, 2008 high. In the current time frame this downtrend now sits at around 1200 on the S&P. The secondary downtrend connects the May 19, 2008 top to the Sept. 1, 2008 top. That downtrend coincided with the 50 day moving average on the 3-year chart and was broken in July, 2009. The third downtrend connects the Sept. 1, 2008 to the Jan. 5, 2009 top. That downtrend was broken in March, 2009. As of now we have broken through 2 of the 3 major downtrends that define this bear market. The S&P has also broken through to the upside of an inverse head and shoulders pattern that developed after a major market sell-off. This is highly bullish and the projected top of the pattern is at about S&P 1200, right where the bear market primary downtrend line now sits. Therefore it appears that the market is going to rally to about S&P 1200. There will be pullbacks and corrections along the way but the overall market direction at this time appears to be upward. What will happen when we reach 1200 is uncertain as there is a lot of resistance at those levels.