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Consolidation, Congestion and Breakouts
5 February 2003 * M.A. Nystrom

February is the shortest month of the year, but the uncertainty surrounding just about everything is making it seem awfully long and worrisome already. Nowhere is this more apparent than in the recent price action in the stock and gold markets. The stock market, as represented by the S&P 500 is consolidating at its recent lows, while gold is breaking out to multi year highs. Whatever this is saying, it is not good. As Richard Russell put it in a recent piece, these are bad omens of things to come.

Since a picture is worth ten thousand words (it used to be a thousand, but that's what inflation will do!), I will try to keep this as short and sweet as possible, and make my illustrations with charts as best as possible. Data is current through Tuesday February 4, 2003.

The S&P 500 has been caught in a wide trading range at the bottom of its recent decline for the past seven days. Students of classical technical analysis know that a consolidation at the bottom of a run is a bad sign. It usually leads to a downside breakout. After all, you can't consolidate forever.

Consolidations such as these give fairly clear measuring implications for the next stop on the bus ride down:

The ride from the previous high to the top of the current range was about 60 points (from 930 to 870). Since consolidations like these usually come in the middle of the run, this implies an equal ride down from the bottom of the current range to the next consolidation or reversal point. Subtract 60 points from 840, and we get our next target of 780. And lo and behold! Seven-eighty is a fairly important number, as the next chart shows:

Seven-eighty is the next major, critical support for this market. It has held twice now, back in July and again in October of 2002. But since October, we've seen lower lows, lackluster price action, and nothing but bad news. The market is running out of steam, and heading back for 780. This third test is critical. Many pundits and analysts are publicly expecting a successful test at best (i.e. a reversal), or more consolidation at this level at worst. Don't bet on it. In situations like this the market can scream right through expected support without even a pause or a glance backward, like in 1987.

In the mean time, gold is powering to multi-year highs. After a recent consolidation around 370, it had a powerful rise yesterday. Since gold and stocks have an inverse correlation, we should expect the broad stock market to break out of its consolidation to the downside soon.

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