The stock market's four-step bottoming process is facing a crucial test, according to Ned Davis Research.
A retest of the stock market's mid-June low is the third step necessary for markets to establish a new uptrend.
"The retest has not failed yet, but the persistent selling pressure of the past week suggests it is a distinct possibility," NDR said.
How the market reacts to retesting those lows will help determine whether stocks are set up for more downside ahead or the start of a new uptrend. But so far the early results "are not good for the bulls," NDR said.
The four-step bottoming process for markets starts with oversold readings, followed by a rally, a retest, and breadth thrusts.
"After the market reaches deeply oversold levels, it eventually mounts a rally. Most rallies are followed by retests of the lows. Successful retests are followed by breadth thrusts, which signal the downtrend has transitioned into an uptrend. Unsuccessful retests mean the process resets to step 1," NDR explained.
While the June to August rally in stock prices included a few breadth thrusts, those eventually failed as the market moved lower. Now a retest is in the cards.
The S&P 500 hit a low of 3,636 on June 17. The popular index traded at 3,638 as of Thursday afternoon. "The retest has not failed yet, but the persistent selling pressure of the past week suggests it is a distinct possibility," NDR said.
A decisive close below that mid-June low suggests that the downtrend will continue until the market hits extremely oversold levels, in which the four-step process would then start over with an ensuing rally, retest, and breadth thrusts.
And a failed retest of the June lows has to be decisive, often confirmed by multiple daily or weekly closes below that level, as sometimes a quick break below the lows could be the sign of final capitulation that leads to a fast snap-back rally. That can be especially true when investor sentiment is at or near rock-bottom, as it is today.
But if the retest holds, it would mean great progress in the stock market's ability to stage a turnaround and establish a new uptrend, as all that would remain on the four-step bottoming process are breadth thrusts, which measure broad upside participation in stocks.
"More breadth failures would reset the bottoming process to step 1. Conversely, a strong rally with not only short-term breadth thrusts but also intermediate-term confirmation would support the case of a new uptrend," NDR summarized.
Regardless of whether the mid-June lows hold as support, a year-end rally remains in the cards for the stock market, NDR added. But if the retest fails and stocks move lower, any year-end rally should be viewed as a bear market rally until proven otherwise, according to the note.
Read the original article on Business Insider