Three weeks ago I wrote an article describing how sentiment indicators (specifically the Rydex Cash Flow Ratio) were showing that people had gotten too bearish too fast. Since then, other sentiment indicators (Investors Intelligence and AAII) have begun to show the same picture, and now our primary internal indicators are also showing that the decline from the August price top may have just about run its course.

The two bottom panels on the chart above give us a picture of the condition breadth (the ITBM) and volume (the ITVM). As you can see, both indicators have nearly reached the lower limit of their bull market trading range. Those limits are not sacred, but they do give us an idea of where we should begin to look for a trading low.

At the top of the chart is the S&P 500 Index, and I have drawn lines across tops and bottoms that result in a pattern known as an ascending wedge. This is a bearish pattern and we should expect it to resolve downward; however, it is not a particularly severe wedge, and there is plenty of room for one or two more bounces off the top and bottom before the pattern finally resolves.

There is still room for prices (and internals) to decline a bit more before the bottom is in place, but that would make the likelihood of a rally even stronger. Also, there has already been a short-term upside breakout on Wednesday (not distinguishable on this chart) that may be the signal that the rally has already begun.

It is worth noting that a relatively minor price decline has used up a considerable amount of negative internal energy, and, even if the decline lasts a bit longer, internal conditions will favor a rally just as support is reached.

That said, I do not have a wildly bullish outlook, because the ascending wedge says that the good times are just about over. I would not expect the rally to last more than a week or two, just enough to get internals back to the neutral zone. At that point the market may have a problem.

© 2005 Carl Swenlin
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