Using technical analysis as our major tool, we have studied the extraordinary, highly volatile recent action of the stock market and have concluded: An upside break from S&P 500 1,173 could result in a powerful but deceptive rally. 

It is common for head-and-shoulder neckline penetrations to reach their objective, reverse, and run back up to or even exceed the neckline, which is at 1,260. Why deceptive? Because these rallies almost always fail since the market’s confirmed direction is down. 

But a downside break from 1,120 could take the S&P 500 deep into the trading range of last summer highlighted on Tuesday’s chart. High volatility is not over since the high-velocity traders will not quit until forced by circumstance or regulation. 

Further study of last week’s price movement revealed that the action was not only unusual, but highly significant. Mark Arbeter of S&P pointed out that there have been just six other occurrences since 1929 when either the S&P 500 or the Dow Jones Industrial Average moved at least 4% for four straight days. The volatility alone doesn’t necessarily signal a bear market, but is a marker that tells us that the technical signals accompanying the volatility are extremely important.

Note the signals highlighted on this chart of the S&P 500: In addition to a neckline break, studied last week, the 50-day moving average (blue line) moved down through the 200-day moving average (red line) signaling a death cross — a very bearish indicator. Also, two days after the neckline break (1,260), the last major pivot high, made in December 2010 at 1,225, was broken. And finally, the Relative Strength Index (RSI) broke below the bull market line at 30. I also pointed out that the Dow industrials and transports signaled that a bear market was under way.

But Friday’s recovery, which closed above the extremes of the week, may result in a dead-cat bounce. But first the S&P and Dow must finish above the closes from Friday, Aug. 5 (S&P 1,200 and Dow 11,445.) That rally could take the S&P 500 to 1,260 to 1,280 before falling to new lows somewhere within last summer’s trading range of 1,040 to 1,130. But if the rally quickly loses steam, look for an immediate thrust to new lows. 

The chances now favor a recovery rally since there is so little resistance above last week’s highs. But the overall trend is now down, so any rallies should be used as an opportunity to sell stocks.

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Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.