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Ripe for a Rally

By Mark Arbeter The S&P 500 and the Nasdaq fell to the lowest levels since 1997 last week, taking out both the lows seen in September, 2001, and the bottom in October, 1998. However, with investors and analysts bracing for further weakness, there are many signs that indicate a counter-trend rally to this vicious bear market is near. Before the all-clear sign is given, there must be evidence over the next few weeks that institutions are getting involved on the buy-side.

The intraday reversal of Thursday, July 11, which was accompanied by very heavy volume on the NYSE (the fifth highest daily total ever), marked another day of minor capitulation in the markets. While many market bottoms occur during massive capitulations, when many sentiment indicators move as one, the current downtrend can best be described as a rolling capitulation, where one after another sentiment indicator moves to a bearish extreme. While it is true that we have witnessed many intraday reversals since May that have all failed, with the market subsequently rolling over to new lows, the technical condition of the market is now in a better position to rally higher from here.

Because the market has fallen so far, chart support levels are derived from activity almost five years ago. We place less importance on support and resistance areas that occurred so long ago, and while they are less significant, they are not insignificant.

There is a much lower probability that institutions that accumulated stock at a particular level five years ago will do the same this time. However, because so many market participants are looking at these areas for support, they may in fact become self-fulfilling. Support for the S&P 500 runs from 855 to the low 900 area, and is pretty thick. For the Nasdaq, minor chart support exists between 1200 and 1300.

What has us most excited about the potential for a market turn is that most sentiment indicators we follow have finally moved to oversold levels usually associated with intermediate-term lows. Last week, volatility indexes, specifically the VIX, moved to levels not seen since September or the last major market low. The VIX, which is considered one of the better measurements of fear, and measures option premium levels on the S&P 100 (OEX), rose above 40 on Thursday and Friday. Since 1997, every major decline has pushed the VIX to 40 or above, and in all but one instance, led to a pretty powerful rally.

One concern is that the VIX did soar to 55 or above at the bottoms during 1997, 1998, and September, 2001, however, those declines were extremely quick and sharp, which pushed fear levels to very high levels. The current downtrend, while very unpleasant, has not been straight down.

The VXN, or volatility index of the Nasdaq 100, rose to 69 this week, also the highest since September. This is close to the level of 74 witnessed during the bear market in 1998, but well below levels of 90 or above printed during April, 2000, December, 2000, and September, 2001. Once again, those levels were achieved during swift price declines in Nasdaq, something that has not happened of late.

Investor's Intelligence poll of newsletter writers, considered an intermediate-term sentiment reading, continues to slowly shift from extreme levels of bullishness to levels more typically seen at market bottoms. The level of bulls fell to 39.6% during the latest survey, the lowest level since early October. Bearish sentiment rose to 36.7%, the highest since early October. Considering the damage the market has suffered over the last couple of years, we would like to see bearish sentiment exceed bullish sentiment. That could occur within the next week or so. During the bottom in September, bulls fell to 33.7% while bears rose to 42.7%. During the lows in '94, bulls dropped to 31.6% and bearish sentiment rose all the way to 59.1%, showing a real distaste for equities.

Because sentiment is a secondary indicator, and is just a precursor to a bottom, it is difficult to tell just how oversold these readings have to go. That is why it is always prudent to wait until prices start advancing and institutions show a clear pattern of accumulation before any confident prediction can be made that a final low is in.

The market is clearly not out of danger, but there have been many signs to suggest that the market is near some type of low. We have seen clear evidence that many investors have thrown in the towel, and that is certainly one component of a bottom. We sense however, that the market will require a clearly bullish catalyst, possibly coming from the upcoming corporate earnings season, to light a fire under the market. Many recent market lows have been created by the Federal Reserve pumping liquidity into the financial system. The catalyst will probably have to come from somewhere else this time.

A decent rally could be near but we suspect a better time to load up on stocks will occur during the third or fourth quarter. Arbeter is chief technical analyst for Standard & Poor's

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