Caution Flags for Stocks

The S&P 500 failed to hold above chart support. The action of the Nasdaq will be a key factor over the near term

By Mark Arbeter

The market turned tail last week in what could mark an important period for stocks. The failure by the S&P 500 to hold above chart support, provided by the almost 3-month price base, in conjunction with a pickup in trading volume while prices were headed lower raises some caution flags once again. The "500" also took out a couple of key trendlines.

To recap some key developments of late, the S&P 500 traced out a sideways price consolidation from early June to late August which was sandwiched between 965.46 and 1,011.66 on a closing basis and 960.84 and 1,015.36 on an intraday basis. The index then broke out to a new recovery high in early September on a nice increase in volume and proceeded up to the 1040 area before beginning the latest pullback.

So far, the Dow Jones industrial average and the Nasdaq composite index have not deteriorated as much as the S&P 500, so there is still some hope that the current decline is just a correction within an ongoing uptrend. A key over the near term will be the action of the Nasdaq, which has led the advance since October. If there is a breakdown here, the red flag goes up.

There are a couple of concerns we have about the latest action in the S&P 500. The first involves the failed breakout that occurred last week. While we did get close to our target of 1,050 to 1,075 during the latest rally, we did expect any pullback to be supported by the floor in the 1,010 to 1,015 area. In extremely strong markets, breakouts usually hold and breakout points usually act as a floor for the market. Until the DJIA and the Nasdaq break down, our near-term call is that the S&P will hold within the price consolidation range of 960 to 1,015.

The second worry about the latest action, and this also applies to the Nasdaq, is the noticeable increase in volume during the decline last week. Volume on the NYSE and the Nasdaq was heavier than average and certainly indicates that distribution by institutions is started to wield its ugly head. The selling on the NYSE was heavier than the last little decline in the averages that occurred in mid-September and was about at the same level for the Nasdaq.

The increase in selling has pushed our accumulation/distribution models on the NYSE and the Nasdaq to neutral from bearish. A couple more days of heavy selling would be required to turn these models bearish.

The S&P 500 took out two trendlines during the week, one short-term and one intermediate-term. The shorter-term trendline was drawn off the low on Aug. 6 and subsequently tested on Aug. 26 and Sept. 12. The break of this minor support line is not a big deal. However, the break of the trendline drawn off the low in October to the subsequent low in August is of more concern. The longer the trendline, the more significant a break becomes.

The last negative, which is small so far, is the minor break of the 50-day exponential moving average. This average lies at 1004, near current prices. Many times during a strong uptrend, the 50-day will act as support, and is a trigger for institutions to jump back in. When it doesn't act as support, whether talking about an index or an individual stock, it is time to take a step back.

The Nasdaq, which has once again become the most important driver of the stock market, is key to the overall health of the market. The critical support area for the Nasdaq lies between 1,776 and 1,800. The bull market trendline that is drawn off the lows in March and August, and has supported the entire advance, lies at 1,800. The 50-day exponential moving average comes in at 1,785, while chart support begins at 1,776, or the price high seen in mid-July. If this area gives way, the next important area of support for the Nasdaq is 1,600. There is chart support here and this level also represents a 50% retracement of the advance since March.

One interesting internal measure of the Nasdaq is the ratio of down volume to up volume on a 10-day basis. Many times after an extended move, this ratio will approach zero, suggesting a buying spree on the index. In other words: How much better can things get? On Sept. 9, this down/up volume measure fell to 0.54:1. While this ratio can remain very low for an extended period of time, it is certainly a sign of speculative market excesses and many times gives off warning signs when selling intensifies and the ratio rises back up to 2:1 or higher.

One sentiment measure, among many, went to an extreme level of bullishness this past week. It is a combination of two short-term polls, Consensus and MarketVane. We add the two surveys and the latest reading of 121% bulls is the highest since April, 1999. While our concerns about the high levels of bullish sentiment have so far been wrong, sooner or later this excess bullishness will have to correct itself. Lower stock prices would do wonders to alter investors' opinion of the market.

The bond market is once again moving counter to the stock market. The yield on the 10-year Treasury note has fallen to near 4%, or the lowest yield since mid-July. The 10-year has moved into a heavy zone of resistance that runs down to 3.8%, so we would be very surprised if we got much of an extension below 4%, unless the stock market really craters.

While the current weakness was not totally unexpected because the major averages had moved up to or near areas of heavy chart resistance, it is a bit too early to tell whether this is the time that momentum can finally pick up to the downside.

Arbeter is chief technical analyst for Standard & Poor's

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