U.S. Photographer: Luke Sharrett/Bloomberg GETTY

Instead of helping to stabilize the market, the FOMC kicked out the already-wobbly legs of investor confidence on Wednesday as the selling got even heavier. Once again, President Trump's 'Keystone Cops' economic team did not help, again coming out with contradictory comments on Friday. As detailed in this MarketWatch article there were more developments after the market close on Friday. The rumors that Trump had been discussing firing the Federal Reserve Chairman were later denied.

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The fact that both the Nasdaq 100 and Russell 2000 lost well over 8% last week was already enough to shake the confidence of the most seasoned investor. The 7.05% drop in the S&P 500 means it is now close to down 10% for the year. This actually looks pretty good when compared the 16.4% drop in the Dow Jones Transportation Average.

The weekend headlines have pointed out that the stock market is on track for the worst December since 1931, when the Dow Industrials dropped just over 17% during the month. Of course, in 1931, the Dow Industrials dropped 52.6%, which followed a 33.8% decline in 1930. Both years made the 17.2% decline in 1929 look minor by comparison.

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The daily chart has the December 1931 period highlighted in yellow. The Dow made its correction low of 69.85 on January 5, 1932, which was the second trading day of the year. Over the next eight days it rallied 25% to 87.78. The Dow formed a continuation pattern in January and February (lines a and b) before resuming its decline in March.

During this bull market, there have been several periods of heavy selling. While most have not been as dramatic as the recent plunge, I think they can be relevant when discussing what may happen to the stock market in 2019. As of Friday’s close, the S&P 500 is down 17.8% from the September high. This is not far above the widely-watched 20% bear market level. A further decline to the 2350 area would be a decline of over 20%. While a 20% drop is often touted as a sign of a bear market, there is very little evidence for that behavior as an indicator of change in the long-term trend.

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The 2015 and 2016 period was the most recent period of heavy selling prior to early 2018. From the May 2015 high of 2134, the S&P 500 declined 12.5% to an August low of 1867. From these lows, there was a ten-week rally of 13.3% back to 2116 in early November 2015. By the time the S&P 500 made its low of 1810 in February 2016, the S&P 500 was down 13.3% from the November high.

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The market’s decline in 2011 is more similar to the current situation both in terms of the panic selling and the extent of the decline. From the high at 1370 on May 2, the market dropped into the middle of June before rebounding back to 1356 in early July.

The downgrade of US debt in on August 5, 2011 came after eight days of heavy selling in the stock market in reaction to the budget debate. After a 10% bounce from the lows, the second wave of selling took the S&P down to 1074 in early October, which was a loss of 21.6% from the May high.

The stock market staged a key reversal on October 4, as it dropped sharply in early trading and then closed the day higher. From that low, it rallied to a high of 1292 on October 28, which was a gain of 20.3% from the October low.

By early March 2012, the S&P 500 surpassed the April 2011 peak and made new highs. It should be clear to anyone that this 20% drop as an indicator of a bear market is anything but definitive. Those who got out of stocks based on the 20% drop in 2011 should be especially suspicious of these proclamations. By the end of 2012 the S&P 500 had almost made it to 1500. At the end of 2013 the S&P 500 had closed above 1800.

This does not diminish the severity of the recent market decline but is provided to illustrate that if a major average declines over 20% it does not mean that a bear market decline of 30% or 50% is therefore automatic.

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The above comparison chart shows price action since late September. Both the Invesco QQQ Trust (QQQ), in red, and the iShares Russell 2000 (IWM), in green, are already down over 20% from the recent high. It is not difficult to imagine that the SPY will also drop below the 20% level, possibly by the end of the year. The SPDR Dow Industrials (DIA) may not make it that low. So what should one expect next?

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The Spyder Trust (SPY) closed the week at $240.70, which was well below the weekly starc- band at $247.41. It was also well below the 38.2% Fibonacci support at $246.14, which makes the 50% level at $231.60 the next target. The starc- band for this week is at $239.40, which is not far above last Friday’s close. The first strong chart resistance on the weekly chart is at $255-$260.

The S&P 500 Advance/Decline line has now dropped well below the October low, which is a sign of weakness. It is now approaching the next band of support for the highs and lows in early 2018 (line a).

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The Invesco QQQ Trust (QQQ) also violated its 38.2% support last week, but is still above next week’s starc- band at $142.46. The 50% support level is at $139.87. The Nasdaq 100 A/D line dropped sharply last week, and is now well below the prior lows. This confirms a new downtrend, line a, as it has formed lower highs and lower lows. It could easily reach the support (line b) from the February-April lows. The downtrend now needs to be overcome to signal that the correction is over.

In addition to the FOMC meeting last week there were eight important economic reports released. The Empire State Manufacturing Index, Housing Market Index, Philadelphia Fed Business Survey and Durable Goods all came in below the consensus estimates.

Housing Starts, Existing Home Sales and Consumer Sentiment were all higher than expected.  The key Leading Economic Index (LEI) came in better than expected for November, but October was revised downward as lower stock prices depressed the LEI.  As the Conference Board commented in their press release “Solid GDP growth at about 2.8 percent should continue in early 2019, but the LEI suggests the economy is likely to moderate further in the second half of 2019.”

The extent of the stock market selling last week seemed to be pricing in a full-fledged recession if not a depression.  Dumping of long held equity positions is consistent with the view that the US economy is going out of business, but I do not think that is the case.

According to FactSet as of December 21st “the estimated earnings growth rate for CY 2018 is 20.3%” and while few expect this rate to repeat in 2019, it is not consistent with the highest level of market selling since early 2016.  It is interesting to note that at the end of 2016 the estimated earnings growth rate for the S&P 500 was only 3.0% as the index was trading near 2200.

According to Yardeni Research the forward PE ratio for the S&P 500 is now 15.3 which is below the five year average. At the end of 2016 the forward PE was closer to 23.  Whether you think the recent market plunge is a very sharp market correction or the beginning of a bear market, the stock market is currently overextended on the downside.

In my view the stock market is like a rubber band that is stretched out too far, so a snap-back (oversold rally) is inevitable. So far in December there have been very few days of positive A/D numbers and some of the A-D oscillators have reached the lowest levels of the past ten years.

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The chart shows the 10 week MA of the A-D based on the NYSE all stock data. It closed Friday at -722. I have added dashed red lines at previous oversold extremes.  For example, at the early 2016 low it reached -544 and at the October 2011 low it was -682.  During the 2010 correction it reached -648 and the lowest reading during the bear market was -676.

Even though this is a holiday-shortened week I would not be surprised to see the market decline even further as a government shutdown will not reassure investors. There are no signs of a technical bottom as it will first take several higher consecutive higher daily closes for the S&P 500 to start the bottoming process. The recent technical damage will take some time to repair.

This “Not Going Out Of Business” rally should take the S&P 500 at least 10% higher and a 15% move is not out of the question. If the S&P 500 does reach 2350, a 10% rally would mean a move to 2485, while a 15% rally could take the S&P to 2702. The S&P currently has strong resistance in the 2600-2700 area.

For those who are fully invested, the rally will be an opportunity to re-evaluate your portfolio and decide whether the level of equity exposure is too high.  Of course, the strength or weakness of the rally will be important as a weak rally will set the stage for a further decline.

For those not in the market I would favor a dollar cost averaging program such as the one I recommended in April of 2016 when the A/D lines overcame the 2015 highs. Make four equal dollar purchases each week in a broadly based equity ETF, like the Vanguard S&P 500 (VOO). Once the daily market bottom is completed you will be able to clearly establish the risk for the position. The strength of the rally will help you determine how long the positions should be held.

My very best wishes for the holiday season.