"This Rally Is Now for Real"

Technical analyst Chris Johnson of Schaeffer's Investment Research sees a bull market in the making -- if not actually here yet

It may not be a full bull market yet, but recent turnaround is no fluke. Such is the view of technical analyst Chris Johnson, director of quantitative research for Schaeffer's Investment Research, whose charts make him an optimist.

"I can say for the first time in a number of years that we're in the building of an actual bottom," says Johnson. He points out that the broad indexes have exceeded their 20-month moving averages and that small investors are coming back into the market. However, he expects some pullback of perhaps 5% to 10% in stocks before the rise resumes.

Johnson suggests that small- and mid-cap technology stocks will be market leaders, and in tech he thinks the outperformers will be semiconductors, networking, and possibly data storage. He mentions specifically Silicon Labs (SLAB ) and ADTRAN (ADTN ).

These were among the points Johnson made in an investing chat presented June 12 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Chris, what's your broad take on the market? Is the rally for real, and do your charts tell you anything different from the fundamental analysts' view?

A:

The answer to the first question is yes. I can say for the first time in a number of years that we're in the building of an actual bottom. In the short term, we could see a short pullback in the area of maybe 5% to 10%. But the market has really placed its bottom.

From the technical aspect, I look at a number of the major broad indexes that have jumped over their 20-month moving averages, and we've had the 20% necessary in some books to say we're back in bull-market territory. Are we in a full-fledged bull? I'd say no, but in the broad scope of things, this rally is now for real.

Q: More specifically, what's your take on the Dow in the next three months? What are the targets?

A:

I believe right now, looking at the market overall, the Dow will be the index of the three that lags the most. We've got a real possibility of moving back down to the 8,500 level, in the shorter term.

After that initial decline, I believe it will move back up very quickly. Toward next year, I believe we'll see the Dow finishing roughly flat from where we are now, say in January of next year.

Q: Coming right off the news, what are your thoughts on Freddie Mac (FRE ) and Fannie Mae (FNM )?

A:

Despite the obvious, which I believe will show quite a bit of short-term downside, I think we'll continue to see some strength in these companies after they get over the fundamental hump of this probe taking place. The short-term weakness is due to the fundamentals, but after the probe is done, they'll move with the market again.

Q: What's your view of the food sector -- stocks like Tyson (TSN ), Sysco (SYY ), Heinz (HNZ )?

A:

Actually, this is one of the sectors that I have for some time been attracted to. Let me explain why. First of all, if I can kind of group this with some restaurants that I find attractive -- these are the kinds of companies that, over the past six months, have garnered a good deal of investor sentiment.

When I look at the put-call ratio, I see more focus on the put side of the market, rather than the calls. These are companies that have been in strong technical patterns. They've been relative strength leaders -- SYY is one of these. And fundamentally, they continue to meet or beat the predictions from those on Wall Street. I believe that buying strength will continue for them.

Q: I would like to know if we have come too far, too fast.

A:

Interesting question...that's what we've heard quite a bit in the press. From a sentiment perspective (our specialty)...I see a market that has gone from being very pessimistic in mid-March to being rather optimistic.

Right now, technically, the pattern that we've seen over the past 120 trading days matches up almost identically with those seen through January, 1999.... However, the extremes are not quite as high. When I speak of sentiment, I'm referring to investors' intelligence readings, the consensus of bullish market opinion, the volatility index, and the put-call ratio.

Yes, we've come very far very quickly, but I believe that, after a short rest period, the market will extend itself even further.

Q: These afternoon rallies -- are they showing that people want to be in the market overnight? Isn't that bullish?

A:

The afternoon rallies continue to show the underlying strength in this market. Morning activity that we've seen for the past few weeks has been reaction to overnight news, and most of it has been negative.... While these announcements continue to affect morning investments, the afternoon activity shows confidence.

One of the things that I continue to be attracted to is that the volume indicator tends to be positive in the New York Stock Exchange during the day, and it's consistent. This activity leads to my short- and intermediate-term bullish posture.

Q: You mentioned a pullback to 8500 on the Dow. What about a possible pullback on the NASDAQ? And to what level?

A:

Currently, we believe small- and mid-cap tech will continue to outpace the large-cap universe. For that reason, I believe strength is to be found in the NASDAQ, while the greatest potential for pullback will likely reside in the larger-cap Dow stocks. Any resistance in the NASDAQ will likely be at the 20-month moving average, which the index closed above last month. Currently, this resides at the 1500 level.

Additional support for the NASDAQ will be found at the 1600 level. Support there will be found due to the fact that this is a 50% retracement level of the January, 2002, high to October, 2002, low.

Q: Do you have an opinion on which sector will have an outperform rating over the next six months?

A:

Following the lead of the outlook for small- and mid-cap tech, I believe that the semiconductor sector, networking sector, and to some extent, the storage companies will show outperformance in the intermediate to long term.

First, these are the companies that normally act as the relative strength leaders out of bottoms. Second, we're seeing more speculation heading into the market -- i.e., investors willing to wager on single-digit midget stocks, stocks like Lucent (LU ) that once held reign over the market, etc.

The third reason would deal with sentiment. These are companies that have been thoroughly beaten down in terms of selling. The more pessimism you see toward these companies, the more selling pressure that has been exerted on them. So I believe that they've truly been oversold in this market and have the potential to be relative strength leaders going forward.

Q: What has been driving this rally? What will continue to drive it? Is it a major shift in sentiment, and if so, what caused it?

A:

First of all, what has been driving this market? For the first time in a number of years, we've been seeing the individual retail investor get involved in the market. I've done recent studies on options volume to see if the individual investors have gotten active there again. There has been a 70% increase in volume since the beginning of the year attributed to these investors.... That leads to part of what is driving this rally.

In addition to the small investor, we're beginning to see institutions reach out with their cash reserve to the long side of the market, and in the next few months I believe we'll see asset reallocations from bonds back into equities.... Yes, there has been an increase in sentiment as we've continued to see investors get more optimistic. Yet the sentiment has not reached exhaustively optimistic levels.

Q: You cited chips, networking, and storage as possible outperformers in tech -- any names for us there?

A:

Actually, yes, and I'll highlight two very quickly -- Silicon Labs (SLAB ) and ADTRAN (ADTN ). These companies have been on my radar since February of this year for a number of reasons. First of all, from a technical perspective, they have been relative strength leaders for some time.

In other words, they have technically outperformed the major indexes. The reason has been because of fundamental growth, with each company meeting or beating expectations and continuing to build their business models as needed.

Despite the fact that we've seen this outperformance and fundamental strength, sentiment has been very negative. Each company has hosted high put-call ratios, indicating that investors continue to try to call the top in their technical price patterns. This activity is normally bullish, as it's indicative of existing sideline cash that at some point will be invested in the companies, driving the stocks to the next level.

And again, strong technical performance, strong fundamentals, and investor pessimism equal upcoming market outperformance.

Q: If you chart the S&P, from a technical standpoint what is it saying?

A:

I see a few things from both a bullish and a bearish perspective. First of all, I see an index that has broken above its 20-month moving average, which resides at 977. From my perspective, taking this significant trendline out has potential bullish implications for the index. I also see a level of 1000 as being potential short-term resistance. So we currently have a squeeze play going on with this index.

Looking forward, over the next few weeks, should the S&P 500 break above the 1000 level, it will have little to no technical resistance until the 1119 level, which is the current level of its 80-month moving average.

Q: Do you like any charts of money-center banks? Or financials generally?

A:

Obviously, some of the financials, the Freddies if you will, have come under fundamental pressure this week. I continue to find the sector somewhat attractive for the individual investor, with the focus on the smaller regional bank stocks.

One stock that continues to stand out would be Fifth Third Bank Corp. (FITB ). These small regional banks continue to take advantage of the expanding services that they offer clients, tweaking their business models so that they continue to do well in lower-interest-rate environments. I believe they will continue to outperform.

Q: What's the technician's view of this stock? What's the future of AOL Time Warner (AOL )?

A:

Currently, AOL has obviously been embattled by fundamental problems -- insider selling and an overall weakening business line. The fact that AOL is beginning to make many changes at a fundamental level provides some strength for the long-term outlook.

From a technical standpoint, however, I see a company that has just broken above weekly moving averages, let alone the 20-month moving average that awaits the stock near the $20 level. Considering the sentiment on AOL -- according to the options activity there are more than two calls for every put currently open. Given the optimism in that options activity and the fact that AOL continues to trade below long-term moving averages, I would personally wait and see if the technicals will firm up in the next few months.

A rejection at the 20-month moving average, along with the current optimism, would force me to be a short-term seller of these shares.

Edited by Jack Dierdorff

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