This Key Indicator is Flashing a WARNING Sign for the Market

The S&P 500 Index — the benchmark used to indicate the health of the overall market — has declined from a peak of 1,370.58 scored in late April to near the 1,320 level, a decline of about 4%. In doing so, it has breached its 50-day moving average and broken a major uptrend line, raising the question for traders: Is this fall the start of a larger correction?

Recent U.S. economic news has been on the soft side and has contributed to the benchmark‘s decline.

#-ad_banner-#Technology stocks fell after the world’s largest tech company, HP (NYSE: HPQ) lowered its outlook due to weakened PC sales. April U.S. housing starts and construction permits were down, indicating continued weakness in the housing sector. U.S. factory output slipped in April, showing further economic weakness.

As the Federal Reserve’s monetary stimulus program, known as “QE2,” nears its end, the economy seems to be losing stem.

And of course talk about default by the Greek government on its debt as well as general Eurozone weakness has cast a cloud over world markets.

So how significant is the fall of the S&P below the 50-day moving average? Is this a normal correction of, say, 5% — or is it the start of something larger?

To answer that question, we should examine the behavior of the S&P 500 in relation to its 50-day moving average. During roughly the past year, since late April 2010, the S&P has dropped below the 50-day moving average only four times: May 2010, August 2010, March 2011 and May 2011.


 
As shown on the chart above, the first time the index fell below the 50-day, it nose-dived 17% from a high of 1,219.80 in late April 2010 to a low of 1,010.91 by early July 2010 (labeled #1 on the chart).

Attempting to recover from this low, the S&P fought its way back to a high of 1,129.24 in August 2010 (labeled #2 on the chart).

Briefly crossing above the 50-day moving average, the index was then quickly pulled back down to a low of 1,039.70 later in the month (labeled #3 on the chart). This was the second drop below the 50-day and a decline of about 8% from August 2010.

After managing to make a sustained recovery off its low of 1039.70, the S&P crossed above the 50-day moving average in early September 2010. It then formed a Major uptrend, reaching a high of 1,344.07 by February 2011 (labeled #4 on the chart). Note how during this period it was above the 50-day moving average virtually the entire time (shown by the blue line on the chart).

Since the March high, there has been a tug of war between the bulls and the bears. For much of February and March, the bears were in control and took the index below the 50-day moving average to a low of 1,249.05 in March 2011 (labeled #5 on the chart). This 7% decline was the third drop below the 50-day moving average.
After the March low, the S&P began to once again make slow, but steady gains. Crossing back above the 50-day moving average, it rose to a 52-week high of 1,370.58 in April (labeled #6 on the chart).

However, it appears the S&P may have peaked at this level.


 
As shown on the chart above, not only has the index fallen below the 50-day moving average, but it has just bearishly broken the Major uptrend line. The drop below the 50-day moving average marks the fourth occurrence in the past year.

Also note how the slope of the 50-day moving average has changed. Slope is important to look at because a moving average is essentially a curved trendline that describes movement over a specific period of time.

The market situation is most bullish when price is above an upward-sloping moving average. Such was the case from November 2010 to February 2011 (depicted by dashed-line #1), as the S&P climbed to its 1,344.07 high.

Price can also be below an upward-sloping moving average. This situation often implies a retest of old highs. In March 2010, when the S&P briefly fell below the 50-day moving average to 1,249.05, the moving average was upward-sloping (depicted by dashed-line #2). Not surprisingly, the index recovered, retesting and eventually exceeding its old high.

The technical situation changes, however, when the moving average slopes sideways. When prices move above or below the  50-day moving average, it shows a sideways trend for the period.

Right now, the moving average has a slight upward tilt, but it is mainly moving sideways. This sideways movement signifies uncertainly in the market, one with no clear direction. Neither the bulls nor the bears are in firm control.

If, however, the 50 day moving averages begins to slope downward and price stays below it for a period of several weeks, then the odds increase that there will be a test of the 200-day moving average. Traders should monitor both the S&P 500 in relation to its 50-day moving average and its slope for important clues as to how severe the correction will be.

Action to take –> Right now, the S&P chart is flashing warning signs. As important as the break of the 50-day moving average is, it’s also significant to note the index’s breaking of a long-term uptrend line that’s been in force since September 2010. However, the 50-day moving average is still sloping slightly higher.

Traders should watch this slope for the next important clue as to the S&P’s behavior. If the slope begins to move lower and the S&P remains below a downward-sloping 50-day moving average, then a correction of roughly 10% from the 1,370 peak could occur. That move would take the index to about 1,240, near the current 200-day moving average.