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Stocks Hit a Speed Bump

From Standard & Poor's Equity Research

The S&P 500 got within a fraction of a point of the cyclical bull market highs on Wednesday of last week before succumbing to profit taking on Thursday and Friday. Bond yields broke down once again while crude oil prices fell to important long-term support.

The S&P 500 closed at 1325.18 on Wednesday, Sept. 20, just a hair shy of the May 5 peak of 1325.76. The Dow Jones Industrials closed at 11,613.19 mid-week, a scant 0.2% below the cyclical bull market peak of 11,642.65 hit in May.

While the S&P 500 and the DJIA were hitting resistance from their May peaks, other indexes including the Nasdaq, the Nasdaq 100, the Russell 2000 and the S&P MidCap 400 were all hitting key levels of overhead supply. It was therefore our opinion that the indexes would pull back, at least for the short term. The question now is whether this is just another small retracement within an intermediate-term advance or is it the beginning of something much worse that takes the indexes back to their June and July lows?

To maintain a bullish stance, we would like to see a shallow pullback on light volume. Key short-term support levels are abundant, in our view, and not too far below current prices. The 20-day simple moving average sits at 1308.62, with trendline support off the lows in August and September at 1307. The 50-day exponential moving average lies at 1294, and there is chart support from the most recent lows earlier this month in the 1290 to 1294 zone. Longer-term moving averages come in between 1275 and 1280, while more substantial chart support is at 1280.

The volume on the NYSE and the Nasdaq during the declines late this week were above the 50-day average, but we did not consider it to be heavy. On the upside, a strong breakout above the May highs would be bullish, in our view, with the next piece of resistance up near 1360. This is from a trendline off the highs over the last couple of years and equates to a move to the top of the bullish channel that has been in place since early 2004.

Daily technical indicators did not confirm the strength by the S&P 500 into Wednesday's high, in our view. The 6-day and 14-day relative strength indexes (RSI) put in lower highs on Sept. 20 than they did vs. the prior price high on Sept. 5. Both the daily moving average convergence/divergence (MACD) and the stochastics oscillator traced out lower highs. The 21-day rate-of-change (ROC) also put in a lower high after the recent price high by the S&P 500. This all signifies a loss of price momentum during the rally in September, and at least the chance for a short-term pullback, in our opinion. More importantly, the weekly MACD and RSI indicators have been putting in lower highs since early 2004, a signal that longer-term momentum is diverging from prices. This leads us to continue to believe that at least one more intermediate-term correction may be ahead of us.

The Nasdaq ran into multiple pieces of key resistance last week, before pulling back. There is a concentrated zone of chart resistance that runs between 2233 and the old highs at 2375. The index moved to a key Fibonacci retracement level of 61.8% of the correction from May to July. Many times, these retracement levels represent areas where profits are taken.

In addition, the Nasdaq ran into key trendline resistance on an intraday basis Wednesday right at 2263. The intraday high on Thursday was 2261.47, just under this piece of resistance. This longer-term trendline is off the lows in 2004 and 2005, and once represented support for the index. When the Nasdaq undercut this trendline, it then became resistance. Often, when an index drops below key support, it will have a kickback rally to that line, and then fail.

Near-term support for the Nasdaq also appears to be plentiful with chart support at 2203 and then 2173. Short-term trendline support comes in at 2207, with the 20-day exponential average at 2198 and the 50- and 80-day average both at 2165.

We believe one of the important keys to a bull market's staying power is stock rotation. Rotation is simply selling out of one stock or sector and putting the funds right back into another stock or sector. The key is that money stays in the market, keeping a floor under share prices. Major corrections and bear markets typically occur when investors rotate out of stocks and move to the sidelines, actually pulling money out of stocks altogether.

In our view, this rotational force has led to gradually higher stock prices over the last couple of years, without a major correction along the way. For instance, when technology peaked in April, and consumer discretionary as well as small- and mid-cap stocks topped out in May, money rotated toward defensive issues, which are typically large cap stocks. Following the market bottom in June and July, money came rushing out of energy and transportation stocks, and poured back into technology and consumer discretionary stocks. We believe the proliferation of hedge funds as well as exchange-traded funds has a lot to do with these rapid rotations from sector to sector. We think the stock market has seen rotational corrections over the last six months, and as long as money flips back and forth within the stock market, we believe the downside will be limited.

The 10-year Treasury yield broke out of a small consolidation last week, and yields fell to 4.6%, the lowest since the beginning of March. The yield on the 10-year has now dropped 65 basis points since the 5.25% peak at the end of June. We remain very oversold on a daily basis, and are approaching oversold levels on a weekly basis. The next area of chart support sits in the 4.4% to 4.6% zone. Long-term trendline support, off the lows in 2003 and 2005, come in at 4.4%. A drop to 4.4% would represent a 38.2% retracement of the entire yield rise from June 2003 to June 2006.

Crude oil prices finished last week at $60.55 per barrel, off another 4.4%. Prices have now declined over 21% since the July 14 peak and are down six of the last seven weeks. We remain very oversold on a daily basis and are approaching oversold levels on a weekly basis. We believe that a short-term rally could unfold at anytime but are still reluctant to call for bottom in crude just yet. We would like to see some sideways action or base building before suggesting that the worst is over. Long-term trendline support sits right near current prices with chart support in the $56 to $60 zone.

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