The market is now getting a bounce-which may even last for the next few weeks-because the indexes had gotten so compressed. The real question is: Where do we go after this bounce? Considering the major unresolved issues still hanging over the market and the lousy technical action we've seen this month, the probability is that the market still goes lower. So no, I am not a buyer here. In fact, if I still held stock, I'd be selling into any bounce I get and raising cash.

 

The extreme whipsaw action we've seen in the market for the past three weeks didn't come out of nowhere. The market's gradual deterioration has been visible for months in the charts of the S&P 500, the Nasdaq, and the Dow and in the charts of leading stocks. As the market continues to act like a top is in, we will probably see more leading stocks top in the coming months. Two months ago, 50% of the leading stocks we track were broken and topped. Now that number is up to roughly 65%. Furthermore, 89% of the U.S. stocks in our database are below their 50-day moving average-a clear sign of weakness.

 

The pool of leading stocks to own shrinks in a poor market environment because institutional investors finally take their profits or start to shift their vast portfolios into more defensive stocks, such as utilities, food, etc. They will, however, hang on to their favorite stocks for as long as possible, either because they like the stock's fundamentals or they believe those stocks have the best chance to weather the storm.

 

In our shop, we have a shortlist of the highest-quality (elite) stocks that we've dubbed "The Super Seven," which includes Apple (AAPL), Baidu (BIDU), Netflix (NFLX), Priceline (PCLN), Lululemon Athletica (LULU), Green Mountain Coffee Roasters (GMCR), and Chipotle Mexican Grill (CMG). In the current market, these stocks are our canaries in the coal mine. When our stock charts for these names start showing signs of large-scale institutional selling (distribution), there's a good chance the market is in a bear phase.

 

Knowing that these "Super Seven" will most likely hold up the longest, we have also been watching the rest of the leadership for early warning signals. In previous blogs, going as far back as May, I've discussed how our individual stock and market analysis has indicated the development of a weakening market environment. And if the market tops additional leading stocks like Amazon (AMZN), Salesforce (CRM), Halliburton (HAL), Wynn Resorts (WYNN), and Ulta Salon (ULTA), for example, then the market direction will be obvious. That said, we won't consider this a prolonged bear market until 80-85% of the leading stocks have clearly topped.

 

Some would argue that the fundamental stories for these companies are still intact, and most of them are. But for us, technical analysis always overrides the fundamentals when it comes to selling. If a stock is breaking down badly on the chart with increasing volume, that fact trumps all fundamentals. The same goes for the major indexes.

 

Best Returns,

 

Scott O'Neil

President, MarketSmith Incorporated

Follow me on Twitter @WScottONeil

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