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Stocks: A Welcome Change in Tone

While there will still be a ceiling on stocks for the next couple of months, S&P also believes there is finally have a floor underneath prices

From Standard & Poor's Equity ResearchThe overall tone of the market has changed for the better, in our view, as bad news is no longer met by new bear market lows. When the market can flatten out and begin rallying in the face of miserable headlines, it may be a sign the worst is over, at least for the intermediate term.

Some of the major indexes have traced out a higher low and higher high for the first time since April, a welcome change in price action. In addition, we are finally seeing evidence of strong accumulation in many of the volume indicators we monitor. While we think there is still a ceiling on stocks for the next couple of months, we also believe we finally have a floor underneath prices.

Short term, the market is a little stretched to the upside, and we believe in need of a minor consolidation or pullback. From the bear market bottom on November 20 until December 8, the S&P 500 jumped almost 21%, the largest 11-day price gain for the index since 1938. The angle of ascent of the November 20 bottom is fairly steep, and we think unsustainable in the near term, so a pause would be welcome, and we think would work off some overbought conditions in price momentum. Long-term bear market bottoms can take time to form, but in our view, it is bullish to see this type of steep price action as it is many times has been seen near major lows. Not all major bear market bottoms take months and months of basing, so it will be interesting to see how this one plays out. With all the horrific news and massive uncertainty, one would guess this bottom will take time to play out.

The S&P 500 has traced out a minor high and minor low since November 20, the first time since the spring that we have at least seen an upside trend develop. However, the index would have to break sharply above the 1006 area to complete any kind of major reversal formation. However, we do not think this is in the cards until we move into 2009, and possibly well into the New Year.

Other potential pieces of near-term resistance come from the 50-day and 65-day moving averages, that sit between 920 and 975. Many times, an initial rally off a major low will run out of gas near the 50-day average. What we are seeing during this sideways price action is a period where the distance between prices and intermediate-term averages are contracting, which is a potential bullish sign. Prices had moved too far, too fast to the downside, and the distance between average prices and current prices become too wide and unsustainable. Eventually things have a tendency to come back to the mean.

While we do not think the November 20 low of 752 has to be tested over the next couple of months, it is certainly a possibility. Many bear market lows end up being double bottoms, but some have been inverse head-and-shoulders (H&S) patterns. Currently, the “500” appears to be working on an inverse head-and-shoulder formation with the left shoulder formed in October and the head traced out in November. Within the larger pattern, there is also a small inverse H&S pattern that has been completed. This smaller pattern formed in November and early December, and, coupled with the minor breakout on December 8, this pattern has been completed. Based on the width of this small H&S, we could see a measured move just above the 1000 level or just at the top of the larger H&S formation.

On the downside, trendline support comes in between 870 and 890, depending on whether you draw the line off the recent low closes or the recent intraday lows. In addition, the neckline of the small inverse H&S pattern comes in around 885, or right near the recent intraday lows. Many times, an index or individual stock that breaks a H&S formation will come back and revisit or test the neckline. Near term chart support sits in the 816 to 850 zone, and we expect any pullback over the next week or two to be contained in this area. Critical support is at the bear market low of 752.

Market internal statistics based on advancing and declining volume have been very impressive since prices bottomed on November 20, in our view. The 10-day summation of Nasdaq advancing/declining volume traced out a bullish divergence in November, and has since jumped to its highest level since 2005. The current volume thrust is many times seen during bear market bottoms and early bull markets. The 10-day NYSE advancing/declining volume also traced out a bullish divergence in November, and is sitting at one of its highest levels since the 2002/2003 bull market was starting. The volume surge into stocks on both indices has broken a downtrend in up/down volume that has lasted almost the last two years. We believe it is critical to see evidence of strong accumulation by institutions as this characteristic is seen during many long-term market bottoms.

The U.S. Dollar Index looks primed for a fall after a very strong rally since mid-July. We think a drop in the dollar would be bullish for the stock market, and, especially, commodities and commodity stocks, which have gotten obliterated. Gold has already rallied over $100/ounce and appears to be working on a very complex bottoming formation. The Dollar index has traced out a head-and-shoulders top, and is close to breaking down. Prices on the dollar index have also broken trendline support off the September low, and we have seen bearish divergences with respect to price momentum after the index got extremely overbought on a daily and weekly basis.

There is little chart support for the Dollar index until the 76 to 80 zone. A drop into that area would represent a potential retracement of 50% to 61.8% of the rally since July, a common giveback after a very strong move. Longer term, we think the dollar is tracing out a massive bullish reversal formation between 70 and 93; however, it could take many more years to complete.

Arbeter, a chartered market technician, is chief technical strategist for Standard Poor's

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