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A ‘head-and-shoulders top’ in the stock market could lead to big downside as the bond market flashes a warning, Bank of America says

Trader Leon Montana works on the floor of the New York Stock Exchange stocks NYSE worry

AP Photo/Richard Drew

  • The S&P 500 is at risk of developing a bearish head-and-shoulders top, Bank of America said.
  • The S&P 500 could fall as much as 15% to 3800 if the bearish pattern successfully develops.
  • The bond market and weakening financial conditions are warning of more stock market downside.

The stock market could be on the verge of a 15% decline as a bearish chart pattern develops amid worrying signs from the bond market, Bank of America said in a Tuesday note.

Bank of America’s technical analyst Stephen Suttmeier is on “head-and-shoulders” watch for the S&P 500, which is a bearish topping pattern that has been in development for six months. 

The pattern takes its shape from a series of three tops, with the second top being the highest of the three. A neckline represents support and is formed by connecting the three bottoms associated with the peaks. When the stock breaks below its neckline, a sell signal is triggered for traders.

According to Suttmeier, the S&P 500 is at risk of the bearish top formation as long as it trades below the range of 4546 to 4600. “

A decisive break below 4278 to 4222 is the signal to confirm the head-and-shoulders top with deeper downside risk toward 4000 and even into the 3800s,” he said.

A decline to that level would be in line with Suttmeier’s finding that the median stock market pullback during a midterm election year is about 20%, according to the note.

In addition to the head-and-shoulders pattern, breadth indicators are beset with bearish divergences, financial conditions are weakening, and the high yield option adjusted spread index is breaking out from a big base, which has been a telltale indicator of more stock market weakness ahead, according to the note.

“The US high yield OAS is breaking out above resistance to suggest a year-long risk-off bottom for this credit spread. Deteriorating credit conditions are a bearish leading indicator, increasing the risk that the S&P 500 completes the head-and-shoulders top,” Suttmeier explained.

But while a peak-to-trough decline of up to 20% would be painful for investors, that wouldn’t mean an end to the secular bull market in stocks. Suttmeier stands by his view that the theme of 2022 remains a correction within a secular bull market.

“The weight of the evidence suggests a mature cyclical bull market from March 2020 heading into a cyclical correction (bear market) within a larger secular bull market,” he said. 

Head and shoulders in S&P 500

Bank of America

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