Why Traders Should Expect More Selling

Editor's note:Serge Berger, the head trader and investment strategist for The Steady Trader , will be providing the Daily Market Outlook until Sam Collins returns on June 27.

The S&P 500, while not the only star on the Street, still holds many of the more valuable clues to reading the market tea leaves. As this is my first day filling in for Sam Collins, allow me to give a brief overview of how we got to current levels before digging deeper into more forward-looking views.

After the cataclysmic drop in 2008 and early 2009, the S&P 500 proceeded to string together a massive 105% rally in 25 months. On the weekly chart, note the red channel in which the SPX has traded up during the entire rally. At present, the SPX looks like it wants to kiss the lower line of this multi-year channel, which comes in just around 1,250.

S&P 500 Chart

Zooming in to the price action so far in 2011, let's first focus on the failed inverted head-and-shoulders pattern that completed its setup in late April. The financial media were all over this pattern, as it was clear to them that this formation would lead to its ultimate measured target near 1,430. (The way one measures price targets of inverted head-and- shoulders patterns is by subtracting the level of the head from the level of the neckline, and adding that difference to the neckline.)

After kicking above the neckline, however, the SPX price quickly lost its momentum, and near 1,370 started to put the gears in reverse. The entire inverted head-and-shoulders formation ultimately failed as the SPX dropped below the 50-day moving average (yellow line) and then swiftly proceeded below the right shoulder level (below the 1,295 level) in the first few days of June.

S&P 500 Chart

But then the S&P 500 got back on its legs and staged a solid four-day rally into the end of May. The classic month-end games played by fund managers bumped the SPX above the downtrend (blue lines), as well as above the 50-day moving average. The prudent traders, however, were aware of this and waited for the first trading day of June to come around for verification of this quick rally.

By now, most people had heard that over the past two years, most of the stock market's gains were a result of the large up moves on the first day of each month. As often is the case on Wall Street, once something becomes public knowledge, it no longer is a valid catalyst. In this case, on June 1, the SPX dropped to the tune of 2.23%, not only getting the better of those that bought the breakout just the day prior, but also completely invalidating that breakout by dropping below the 50-day moving average and retesting the May lows.

S&P 500 Chart

And that brings us to current levels. The S&P 500 has now had a serious case of the blues, as it closed down six days in a row, which is something that has not come to pass since February 2009. After six down days, an oversold bounce is to be expected, and that is what we got yesterday.

From a momentum oscillator point of view, both the Relative Strength Index (RSI) and the stochastics indicators are in oversold territories and support a brief bounce higher. The thing to remember about momentum oscillators, however, is that they, unlike stock prices and moving averages, are range bound, and as such, have nowhere else to go but stay or reverse once an extreme reading has been hit. Generally, I prefer to use oscillators as indicators when they show divergence from the price action. I will touch more on this in coming days.

The obvious and potentially easy trade here is down to the 1,250 area, which not only coincides with the bottom of the trading channel on the weekly chart discussed above, but also with the March lows and the 200-day moving average (red line).

We simply haven't had a washout day in this most recent sell-off or any clearer sort of reversal pattern. Additionally, yesterday's lack of participation of the rally leaders like Apple (NASDAQ: AAPL ) further adds credibility to the thought that we are not yet done testing the downside.

S&P 500 Chart

The tape is tricky at this stage as crosswinds ranging from the U.S. debt ceiling to Europe to China's growth are howling through investor's portfolios. SPX 1,300 is a nice and clear level for bears to watch. If they can't rally meaningfully above it on a daily closing basis, then the trap doors to 1,250 are more than likely to trigger.

Let's evaluate one day at a time, keep our minds open and our stops defined.

For one stock to buy now, see the Trade of the Day .

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 .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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