Indexes could make new major cycle highs -- or not

Despite lower openings in overseas markets Sunday night with the S&P 500 Emini contract sinking as much as 18.75 points initially on fears of a U.S. debt default, overall stock market action over the past several months reminds us of a comment made awhile back by a seasoned trader. He said, "When the market gets into a trading range draw a line across the highs and then draw a line across the lows. When the market breaks above, or below, one line or the other, take action." That advice seems in line with market movement since May when the major indexes eked out new highs and a "top" line could have been put in place. A lower parallel line would connect the June and March short-term lows.

Despite threatening on the downside over the past several months and without final resolution, it is once again the upper boundaries that have taken on renewed significance. With the S&P 500 up 2.1% last week, the Dow Industrials up 1.6%, the NASDAQ ahead 2.4%, and the Value Line Index a gainer by 1.5%, the market collective is threatening to make new highs by reaching the best levels since the March 2009 lows.

But over the past few weeks we have also been suggesting that index price action may have been tracing out Head and Shoulders Distribution Tops characterized by Left Shoulders formed into the February short-term highs, Heads created with the May peak and higher highs, and now the potential Right Shoulders equal to the Left. Underscoring the formation of the H&S top has been the deterioration in Volume, one of the key components of such a pattern. That tendency has been most pronounced in our Cumulative Volume series which has been steadily deteriorating since the February highs.

Of course, given the perversity of the market and its tendency to destroy the "best laid plans of mice and investors," because there has been no downside resolution, we still cannot rule out the possibility, Sunday’s early weakness notwithstanding, our Head and Shoulders Top scenario fails and new highs follow. Simply put, the developing Right Shoulders could morph into higher highs than the May peaks of the patterns.

If such eventualities develop, there is something else which might be occurring. Keeping in mind that most investors tend to get "hooked" at market extremes to the extent they tend to buy more into major market highs and sell more into major market lows, a perfect trap in this environment would be for the market to create new highs while suggesting a resumption of the primary bull trend.

But why do we suggest such action would be a draw play?

S & P 500 Index with Cumulative Volume

Because of the ongoing status of our key indicators. At this juncture, Cumulative Volume, the Most Actives Advance/Decline Line (MAAD), the Call/Put Dollar Value Flow Line (CPFL), and Major Cycle Momentum are not positioned to confirm new highs by index prices. In other words, it would be entirely possible the major indexes could rally to new highs, but the internal mechanics of the market would not confirm such strength. Similar divergences developed into the 2000 and 2007 market highs.

There is also the possibility that new highs in the major indexes could lead to the formation of Broadening Tops in the indexes (see the accompanying S&P 500 Cumulative Volume chart) which can be characterized by higher highs and laterally developing bottoms. With Broadening Top formations there is also deteriorating volume as the patterns progress to resolution. So, at this point, pattern formations could be either the end of the Head and Shoulders Top scenario with the broad market about to head lower, or the beginning of movement to new highs as the Broadening Top idea gains traction.

S & P 500 Emini Futures contract with Cumulative Volume

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