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The Federal Reserve could trigger this major stock market sell signal

Brian Sozzi

Wall Street’s bears could be poised to return from their September hibernation and devour bull carcasses at will if technical stock strategists are right.

The S&P 500 is nearing the often dreaded “double-top” chart formation after defying conventional wisdom on the U.S.-China trade war this month and climbing back to record highs. At 3,007 as of Friday, the S&P 500 Index is a stone’s throw away from its record intra-day high of 3,027 hit on July 26.

A double-top chart formation is viewed by technical analysts as a bearish reversal pattern. It's characterized as two consecutive peaks (in this case July 26 and the one that is currently approaching) that are almost identical, with a decent-sized trough in the middle (late July through late August here).

Should the S&P 500 fail to convincingly ride its latest momentum beyond the July 26 high on a closing basis, pros will likely view it as buying appetite having run its course in the near-term. Without another dose of positive news on the trade war front or from third quarter corporate earnings pre-announcements, investors could have valid reason to dump stocks ahead of fresh tariffs going into effect in mid-October.

Miller Tabak strategist Matt Maley points to the significant double-top formations on the S&P 500 in 2000, 2007, 2011 and 2015 as all being followed by sizable corrections in the market.

“Double-tops are very important in technical analysis…and even if they don’t take place frequently, they are usually very compelling developments,” Maley says.

Those in search of the catalyst for a double-top, bearish reversal should look straight at the Federal Reserve.

Federal Reserve Chair Jerome Powell presents the monetary policy report to the Senate Banking Committee, July 11, 2019, on Capitol Hill in Washington. (AP Photo/Jacquelyn Martin)

The Fed as a bear

It’s widely expected that come September 18, the Federal Reserve will have slashed interest rates by another 25 basis points. The statement on the Fed’s decision will probably play up recent lackluster reads on manufacturing, a slowing U.S. labor market and ongoing trade risks as the underpinnings for the rate cut.

But, the wildcard on the day according to those on Wall Street will be the Fed’s updated dot plot. The dot plot is used to signal where those on the Fed see interest rates headed in future years.

As for this meeting, it’s unclear if enough Fed members will plot out a path for lower rates. If that occurs, it may be the signal for the market bears to return — remember, the market’s algos love promises for lower interest rates perhaps more so than President Donald Trump.

“We expect the dot plot to show further movement downward in the dots, if nothing else in order to reflect the rate cut in July. But the average may not move dovishly enough to satisfy market expectations and the media is unlikely to show an additional 50 basis points in cuts by the end of the year,” Morgan Stanley economist Ellen Zentner says.

Goldman Sachs is also not convinced that the Fed’s dot plot will be of the extra dovish variety that the markets want.

Notes Goldman Sachs strategist Jan Hatzius, “We expect the dot plot to show that a substantial minority, roughly six participants likely including the Chair and Vice-Chair, expect a third cut later this year. We think such an outcome would send a strong signal of a third cut and would not be taken as particularly hawkish by investors, even though the median dot would not show further easing.”

Pay attention to chart formations

Technical stock analysis is not hocus-pocus. Studying key chart formations are a great way to gauge sentiment in the market and if it’s signaling potential bullish or bearish moves.

In this latest case, respect the double-top especially after the rather against the grain rally we have seen in stocks this month. Stock prices presently reflect rising hope on trade negotiations with China, despite not having much changed at all. Markets also continue to bake in a steady dose of interest rate cuts by the Fed.

That collective optimism could easily be beaten out of investors with one Trump tweet... or one less than dovish Fed meeting.

Brian Sozzi is an editor-at-large and co-anchor of The First Trade at Yahoo Finance. Follow him on Twitter @BrianSozzi

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