U.S. Stock Market: Who Has the Upper Hand Now - Bulls or Bears?

To say the U.S. stock market has been sending conflicting signals to U.S. stock investors lately would be an understatement.

Wall Street notched another wild week this past week, with the Dow Jones Industrial Average (DJIA) first rising to trade above 11,450 before plunging more than 600 points to close Friday at 10,817 and traders and other market analysts say the volatile conditions are likely to continue, near-term.

What's more, over the past four weeks the Standard & Poor's 500 Index, or S&P 500, has recorded its biggest four-week loss since March 2009, and the index is down 16 percent to 1,123 since July 22 -- a drop that's erased $3 trillion in value.

What's leading some traders to hit the sell button? Two factors.

First, institutional investors -- the hedge funds, investment funds and mutual funds that determine the market's value -- are concerned that the U.S. economy is not merely in a soft patch but may be tipping back into a recession.

Up until early summer soft U.S. consumer spending and domestic demand was offset by strong international demand for U.S. products and services, and many investors were prepared to cut the stock market some slack because many U.S. corporations, such as General Electric (GE) and Caterpillar (CAT), generate a considerable portion of their revenue and earnings from exports to international markets.

However, over the past two months -- and especially in the last four weeks -- concern has grown that Europe's government debt problems, also called sovereign debt, will both slow Europe's economy and tighten credit markets again, if key banks in Europe incur large losses stemming from holding risky government bonds, such as those issued by Greece.

For the better part of two weeks, there's been chatter in Wall Street circles that a major French bank was insolvent, and if that's the case, the financial crisis will have entered its third phase, after the Lehman Bros. collapse, and the original European sovereign debt issue, Greece.

Since the bank rumors started, no credible, substantive evidence has emerged relating to the France concern, but that did not prevent hedge funds and other short-term players from hitting the sell button.

Short-Term Investors Continue to Exit Market

Further, amid a tepid U.S. economic recovery that's not creating enough jobs to substantially lower the very high 9.1 percent unemployment rate, it doesn't take much to prompt many short-term institutional investors to bail on stocks.

Typical U.S. investors -- the typical person who owns 6 or 8 stocks as well as mutual funds in a 401K -- should keep in mind that many institutional investors have done quite well -- racking-up impressive capital gains during the 2008-2011 period -- hence any substantive sign of bearishness or enduring economic weakness encourages them to lock-in 40 percent or 50 percent capital gains (and larger) etc.

Last week's stock market turbulence and selling also can be attributed in part to another appearance by the bond vigilantes, who appear to have turned their attention now to France on the aforementioned bank insolvency chatter, after hitting the bonds of Greece, Ireland, and Italy earlier in the financial crisis.

Economist Ed Yardeni, who now runs Yardeni Research Inc. of Great Neck, N.Y., coined the term bond vigilantes in the 1980s to describe the institutional investor practice of selling bonds and shorting bonds of governments when they see unsustainable fiscal policies and/or other actions by governments or companies that the institutional investors believe will lower the value of the bonds issued.

Two Views of Market

With the above as background, what's ahead for the Dow and the markets? Here are the arguments:

The bears continue to argue that absent adequate, sustained, monthly job growth of at least 150,000 to 200,000 new jobs per month, the U.S. economy will continue to grow at, at best, a tepid rate, weighing on both corporate revenue growth and earnings growth. Hence, the bears see a Dow falling to 10,000, and possibly to 8,100.

Conversely, the bulls argue that the Fed's commitment to low interest rates through mid-2013 will telegraph to companies that borrowing rates remain conducive to expanding operations, and when combined with modest median income growth by consumers, that should be enough to enable the U.S. economy to progress to a self-sustaining expansion --- Fed Chairman Ben Bernanke's goal.

Technical Indicators: Mostly Bearish

Further, from a technical analysis standpoint, the bears still hold the edge: the Dow is below the key 50-day moving average at 12,027 and also is below the 200-day moving average at 11,993 -- an even tougher average to break. Further, aside from intra-day, 3- to 4-hour rises in the Dow, there's also a lack of buying pressure -- another bearish factor.

What's more, the bears can claim another technical indicator: the relative strength index (RSI), which is now at 34.9. Readings below 30 indicate the market is oversold; above 70, overbought. The RSI fell below 30 during the past month, then rallied above 40, before falling again -- and that's consistent with short-covering by the market's bears.

What can the market's bulls hang their hat on? If the bulls can hold support at/near Dow 10,700 to 10,800 it could serve as a base for new rally, However, investors should keep in mind that it could take weeks or even months for the Dow to successfully hold support at 10,700 / 10,800. It's going to take the entrance of new money -- new investors deploying money to stocks, to get the Dow to stay above 10,700 / 10,800.

If the Dow falls below technical support at 10,700 / 10, 800 it will likely fall to 9,700. The Dow 10,000 level represents major psychological support, but again, it's unlikely to hold, absent new money coming in to the market.

If the Down falls below 9,700 it could drop to 8,100 -- the next technical support level.

Market/Economic Analysis: Economists, market analysts and sector analysts are now trying to detect patterns in the Dow's recent moves that parallel previous bearish periods, but there aren't enough data points to incontrovertibly claim that the current period mirrors 1987, 2008, or 1929, etc.

What's the best stance for typical investors at this stage? If you can tolerate the risk associated with owning stocks, dollar-cost-average with quality companies. In other words, look for companies with demonstrated business models in established markets and buy in stages. With an S&P 500 P/E ratio of about 12.3, many companies are on sale -- i.e. they're selling at a low price. Again, the key is having the ability to wait-out soft market conditions. This is not a stock market for rookies, squeamish investors, or those to tend to worry at night if the stock market has had a few bad days in a row.

More generally, as discussed, look for choppy, volatile trading to continue, until institutional investors can reach a consensus concerning whether the Fed's new, two-year low-interest-rate stance will provide enough stimulus to rev-up U.S. GDP growth or some other good news appears that indicates that the U.S. economic recovery is strengthening, or at least not ending.