-Dugald Malcolm

Montreal, Canada.

Technical analysis is a great and helpful tool for making investment decisions. I particularly like it as a good way to make emotion free, simple and logical timing decisions with regards to whether or not to buy or sell. Sometimes, however, the charts throw you a curve ball and indicators start becoming anything but simple.

The S&P 500 Index has rallied a dizzying 51.5% off its low made in March. Does this mean that the bulls have defeated the bears and that the market is giving us a screaming buy signal? Let's look at the charts and see what they reveal:

At first glance, the indicators seem quite promising. After spending close to a year and a half below it, the S&P 500 managed to break above the 200 day moving average in June , and, more importantly, managed to stay above it. Then, later that some month, we had what is called The Golden Cross, where the 50 day moving average crosses above the 200 day moving average. So far, so good.

On closer inspection, the charts reveal a pattern that formed since the fourth quarter of 2008. While Head-and-Shoulder Top Formations are more common, forming over periods of just a few weeks, the inverse pattern, called a Head-and-Shoulder Bottom Formation, usually forms over periods of several months. The Head-and-Shoulder Bottom Formation usually signify an important reversal pattern from a downtrend to an uptrend. The pattern is completed following the Right Shoulder when prices break above and subsequently closes 3% higher above the neckline. This occurred on the above chart of the S&P 500, where the Head-and-Shoulder Bottom Formation broke above its neckline and closed 3% higher in July.

So is that it? With all these indicators signalling that a reversal occurred, should we jump into the market and enjoy the new uptrend? Not so fast...

While everything seems hunky dory on the surface, some strand lurks below - quite literally below, on the chart above. As Eric touched on in his blog last month, something strange is happening with regards to the trading volume. Bottoms tend to be hit on low volumes, with most people scared right out of the market. Recovery rallies, on the other hand, tend to be accompanied by high volume. This time, however, the reverse is true, with volume in this rally way below the peaks seen in March.

The breaking above of the moving averages and of the Head-and-Shoulder Bottom's neckline would be very convincing if it were not for the sheer lack of volume that accompanied them. For these moves to be truly valid and compelling we need to see volume significantly increase when they occur. Until such time, these indicators are iffy , at best.

Another sign that makes one question the validity of this new so called "uptrend" is that it is going against historic norms. Usually, after hitting the bottom, the market will usually test that low shortly thereafter. The low made in 1974, for example, was tested two months later and the low made in 2002 was tested five months later. While dipping ever so slightly from mid June to early July, this market certainly has nowhere near tested its March lows.

Combine the lack of testing its lows, the lack of convincing volume, and the lack of fundamentals ,which Eric has alluded to in numerous blogs, this market seems to be propped up on whimsy and not much else. It seems that, at least for now, the safest place to be is on the sidelines until a true indicator with some conviction comes along to change our minds.