Stocks smashed through a major line of technical support yesterday, with all three major indices ending Q2 with a loss and at new annual lows. Wednesday’s tumble resulted in losses for the quarter of 10% for the Dow Industrials, 11.9% for the S&P 500, and 12% for the Nasdaq.

A weak jobs report from Automatic Data Processing (ADP) was blamed for the meltdown. But stocks were holding their own until the last hour, even though the ADP report was published just after noon.  

The mood at the opening was cautiously optimistic following a good result from a short-term debt issue by the European Central Bank (ECB). And a positive report from the Chicago area’s manufacturing activity also contributed to a higher opening.

The heavy selling started following a report that Moody’s has placed Spain’s debt on review for a possible downgrade. But why should the market sell-off on this news when both Fitch and S&P had already cut Spain’s rating?

The euro traded higher versus the U.S. dollar, closing at $1.2229, up from $1.2197 on Tuesday.

At the close, the Dow Jones Industrial Average was down 96 points to 9,774, the S&P 500 fell 11 points to 1,031, and the Nasdaq was down 26 points to 2,109. 

The NYSE traded 1.4 billion shares with decliners over advancers by almost 2-to-1. The Nasdaq traded 687 million shares, also with decliners ahead by less than 2-to-1.

Crude oil for August delivery fell 31 cents to $75.63 a barrel, and the Energy Select Sector SPDR (NYSE: XLE) fell 39 cents to $49.68, its lowest closing price since August 2009. 

August gold rose $3.50, settling at $1,245.90 an ounce. The PHLX Gold/Silver Sector Index (NASDAQ: XAU) was off 0.27 points to 177.63.

What the Markets Are Saying

There is just no way to put a good face on yesterday’s late-day crushing of the primary support for the major indices. As analysts try to make sense of the selling, no fundamental analysis explains what happened.

But to those of us who follow technical analysis, the penetration of the neckline of a possible massive head-and-shoulders top must be studied. We need go no further than the charts themselves to understand the implications of the event.

First, let’s examine closely whether the breakdown of the S&P 500 is really a head-and-shoulders break. Although it is one of the most graphic signals, it is also one of the least understood.

The classic pattern occurs only at market tops, and not in the midst of an already established decline. This pattern did occur at a market top following a broad advance from the bear market low of March 2009 to the peak, or head, on April 26 of this year. Chalk one up for the bears. 

The left shoulder of the pattern is the culmination of a strong rally following an extensive advance and is always lower than the head but higher than the right shoulder. This recent break conforms to the ideal since the left shoulder’s high was at 1,150 and the right was at 1,122. 

Next, volume on the advance up to the right shoulder should be lower than the advances up to both the left shoulder and the head. Again, this is accurate. Remember my continued complaint of the very low volume on advances versus the volume on declines in the month of June. 

And, finally, there must be a break of a well-defined neckline by at least 3% of the total value of the stock (index) at the point of penetration of the neckline. Well, we do see a very well-defined neckline, and it has been violated. But in order to have a confirmed head-and-shoulders we must have at least a 3% penetration of the neckline.

That means that this formation, as ugly as it looks, does not yet conform to the classic definition of this major reversal pattern. We must see a further decline to 1,009 before we are able to confirm that a new bear market exists.

Now you may say, “Picky, picky. The charts of the major indices look lousy. Stop hedging yourself, Collins, and call it for what it is.” 

My answer to that is simple: Words have meaning and technical analysis has very specific, time-tested definitions for each term that we use. You may discard them if you wish, but if you do, then you are running on a hunch, and hunches don’t usually make money.

Here is the way I read the current outlook: Following a further swift decline, new money from institutional investors may be put to use early in Q3, driving prices back up through the “neckline,” and perhaps to the S&P’s 20-day moving average, or even the 200-day moving average. If that occurs, look for another downside reversal that could test yesterday’s break. It is that decline that will tell us if we have broken into a new bear market. But if the S&P and its companions fail to rally, drive immediately lower and establish losses of 3% below their respective necklines, then the bull will be dead and a new and ferocious bear will tear into the market.

Today’s Trading Landscape

Earnings to be reported before the opening include: Constellation Brands, Methode Electronics and MSC Industrial.

Earnings to be reported after the close include: Demandtec and Flow.

Economic reports due: motor vehicle sales (the consensus expects 8.9 million), Monster Employment Index, jobless claims (the consensus expects 450,000), ISM manufacturing index (the consensus expects 59), construction spending (the consensus expects -0.5%), pending home sales index, EIA natural gas report, Fed balance sheet and money supply.

If you have questions or comments for Sam Collins, please e-mail him at samailc@cox.net.