I’ve toned down talk of Armageddon in my comments here recently, even though I remain convinced the U.S. and global economies are inching toward a deflationary bust of millennial proportions. Stock charts have helped to temper my bearishness, since most have been pointing at least moderately higher. This was certainly true back in May when I told you to prepare for  the “tediously bullish” summer that has indeed unfolded since. Not that a tepid stock market has muffled the hubris of the bulls, who continue to embrace the illusion that an economy hopped-up on debt is the very picture of health and vigor. They will doubtless revel in this folly until the day the bottom drops out – which is to say, when the Fat Lady sings…on CNBC.

We cannot know precisely when this will happen, but it’s not difficult to imagine a sequence of events that could turn today’s ebullience quickly to fear. In my scenario, an “unexpected” downturn in the stock market comes first, undermining investors’ confidence and adding crushing weight, both real and psychological, to our debts. As the stock market’s slide deepens, the consumer economy and asset values crash, setting the stage for a balky, 1930s-style recovery that would take at least a generation to achieve critical mass.

Screw Instinct

Some of you may be wondering at this point how an “unexpected” downturn in the stock marklet can be predicted. The answer is, it can’t -- although hardly a day goes by when I don’t hear from some market-savvy pen-pal eager to give this oxymoronic and manifestly futile task a try. And yes, I’m no stranger myself to the embarrassment of having one’s errant forecasts recalled by others. That’s why I’ve become increasingly engrossed in my stock charts and focused on outcomes that are more or less predictable. In this game, perhaps uniquely so, instinct by itself is more likely to lead one to a mirage than to a bottom line.

(Click on chart to enlarge)

Nevertheless, and at the risk of having this forecast hurled back in my face six months from now,  I am going to make a very specific – and very bearish -- prediction that comes partly from my charts, partly from the gut. First, the chart -- a monthly graph of the S&P 500 cash index that is shown above. This is one I rarely look at, since it yields relatively few trading opportunities. Also, to the extent it leads us to wonder idly whether we’re in a bull market or bear – which is to say, leads us to our navels – the labored scrutiny of longer-term charts can only taint, or at least dim, our financial acumen.

Even in a state of dimness, however, can we see warning signs in this chart that practically assault the eye. Specifically, the S&P’s rise since last August has generated markedly declining stochastic peaks. Typically, when such patterns appear, the more pronounced the divergence, the more bearish its implications. In this case, the divergence is extreme -- nearly as bearish as it gets. I say “nearly” because one more element must fall into place: the formation of a third stochastic peak in conjunction with whatever price peak impends. The pattern is quite bearish as is, but if the third stochastic peak occurs between peaks #1 and #2, it would create the most ominous type of divergence of all – a “double divergence” that exists not just between two tops, but between each and all of three tops. We should further infer that a fall from this overbought constellation would be of exceptional magnitude, since it would take oversold extremes to fully correct it.  

Bull Could Triumph

A bullish resolution is also possible -- one that merits more than a passing mention, since we cannot afford to wed ourselves to a scenario that admittedly is highly speculative at this point. To be specific, the SPX cash index would need to leap dramatically higher and to sustain its upward momentum for at least 4-6 days. That would suffice to strand the third stochastic peak above the two that preceded it, sending the bear into a presumably long hibernation. 

Over the next two to three weeks, probably, we will be patiently observing price action in the SPX. My outlook for the near-term remains bullish, but we shouldn’t presume one way or the other, for I cannot assert right now with any great confidence that a bullish outcome is any more likely than a bearish one. However, I can provide you with a precise rally target that could prove very helpful in determining whether an important top has been formed. The target is in the paid-subscriber section of Monday’s Rick’s Picks, but it can be accessed by anyone simply by clicking here for a free one-day pass to the site.