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A Time for Caution

By Mark Arbeter The price consolidation for the S&P 500 continues after a poor showing by the equities market last week. The "500" has been confined to a trading range since early June and it appears the weight of the evidence is starting to point to a breakdown below the current trading range. It is a time to be cautious towards stocks with an eye on the exits.

The S&P 500 has traded within the 974 to 1012 range for the last 8 weeks and a break of either one of these levels will be key to the future direction of the index. What is interesting to note is that the range for the index over the last two weeks has constricted as volatility has declined. The range over the last two weeks has been 979 to 999 on a closing basis. We will address this narrowing of the price range a bit later.

There are a number of reasons we believe the market will head lower over the intermediate-term. The first is that the market has run-up quite a bit since the lows in March and is certainly due to see some profit-taking. The index has lost its price momentum, and while this alone does not suggest that the market will head south, it is one of the components of an intermediate-term top. As we pointed out, the "500" has already broken its up trend line off the March lows, another strike against the index.

We also wrote a couple of weeks ago that the 21-day rate-of-change, an important measure of momentum, fell below zero for the first time since mid-January, and this is usually an indication that the market will move sideways at best, and possibly enter a decent-sized correction.

The second reason for our cautious stance toward equities is the continued high levels of bullishness among investors. Investment polls are and have been heavily slanted toward the bullish camp for weeks if not months and we believe this at least puts a lid on prices. Since the bearish sentiment on Investor's Intelligence poll fell below 20%, the market has gone absolutely nowhere.

The latest sentiment indicator to issue caution towards stocks was the VIX or volatility index. The VIX recently closed below 20 for the first time since March, 2002, and this has not been a good sign for equities. Since 1998, a move to 20 or below in the VIX has usually preceded a correction. While there is no magic number, an increase over 25 by the VIX (currently 22.94) will probably signal that stocks are in the early stages of a correction.

Another reason for our guarded posture towards the market is the negative weight seasonality plays on stocks. With many on vacation in August, trading volumes will contract and therefore the market will not have the fuel needed to break out to the upside. The fall months have been particularly rough on equities with many corrections occurring in the September/October timeframe culminating in a bottom near the middle of October. Seasonals then become much more favorable as the market moves into the period between November and January.

A terrific warning sign that the market may be headed for a fall is the price action of leading stocks. These are the stocks that have led the advance since March and are characterized by very high relative strength numbers. Just this past week or two, there was some definite weakening in some of the Internet, biotech, managed care, homebuilding

and financial stocks. This is certainly not a good sign and suggests that institutions are backing away from the market and booking some nice profits.

Along the same line, many small and micro cap stocks have had extraordinary runs, suggesting a high degree of speculation in the marketplace by individual investors and hedge funds.

Earlier, we mentioned that the S&P 500's range had contracted to a very narrow price range. This can be measured by looking at Bollinger bands around the index. These bands are wrapped around a 20-day moving average and widen and narrow depending on the price volatility of the underlying security. Bollinger bands are plotted two standard deviations above and below the 20-day moving average. Since standard deviation is a measure of volatility, the bands are self-adjusting, widening during volatile markets and contracting during calmer periods.

The bands of late have become very narrow and one interpretation of Bollinger bands is that sharp price changes tend to occur after the bands tighten, as volatility declines. So one way or the other, this technical indicator is suggesting that a big move should occur in the not too distant future.

The bond market has gotten crushed for six of the last seven weeks and in some measures, is more oversold than at anytime in years. The yield on the 10-year Treasury note moved right up to a major bullish trendline on Friday, Aug. 1. This trendline is drawn off the yield highs in early 2000 and has contained yields since then.

We would expect at least a partial recovery in bonds (drop in yields) over the near-term, but are very cautious on bonds over the longer-term. The 10-year Treasury could move back to about 4%, where major resistance lies. This would also represent a common Fibanocci retracement of 38.2% of the latest move. Arbeter is chief technical analyst for Standard & Poor's

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