A Period of Consolidation

The major stock indexes should continue to work off their intermediate-term overbought condition

By Mark Arbeter

The stock markets' attempted rally last week left a lot to be desired as volume levels on both the NYSE and Nasdaq came in well below average. The price reversal on Friday, Feb. 27, was not a positive development either and adds to our cautious tone. It is certainly possible that the recent lows on the major indexes will be taken out to the downside as the current consolidation or pullback continues.

As we have already mentioned, most of the damage to the market has been witnessed in the Nasdaq. From a broader perspective, stocks that have advanced the most, either off of the October, 2002, or the March, 2003, low, have seen the most weakness. Money has come out of the most aggressive areas and has rotated back to more conservative issues. This is exactly what is supposed to happen in a bull market and it is the reason that the S&P 500 has held up so well of late. As long as this rotation continues, the bull market will be able to extend itself above the most recent highs. A bull market gets in trouble when the rotation is directed into fewer and fewer stocks, and so far, that is not apparent.

Certainly, the Nasdaq and some of its major components look the most susceptible to further and more outsized losses in the short-to intermediate-term. The index is sitting in between very important support and resistance, so the action over the next week or two should be very important.

The Nasdaq has closed below its 50-day exponential moving average, currently at 2,037, for five straight days. This is the longest breach of this technically important moving average since the rally began back in March, 2003. Even if the Nasdaq can mount a rally and close back above the 50-day, there are other pieces of resistance that will have to be dealt with just overhead. The 20-day moving average, which is declining for the first time since August, lies at 2,051. Trendline support drawn off the August low has been busted and now represents resistance and this line comes in at 2,065. In addition, chart resistance is at 2,090.

Fortunately for the Nasdaq, and a reason we think the downside will be limited, is that there is strong chart support not to far below current levels. The first area of support is the most recent low at 1990, which was the top of a trading range during the months of November and December. A thick zone of chart support runs from 1990 all the way down to the 1800 area. Long-term support, provided by the 200-day exponential moving average, is at 1865.

The semiconductor stocks, as represented by the Philadelphia Semiconductor Index (SOX.X ), also looks a bit tenuous at this point. The index peaked on Jan. 12 and at its lowest level, was down 12%. The index has also dropped below its 50-day exponential moving average, having closed under it for the last six trading days. On an intraday basis, the index failed right near the 50-day on Thursday and Friday, exhibiting that it represents an important resistance level.

The one minor positive for the SOX is that it did not move to a new low during the latest pullback and may be attempting to trace out a double bottom. We doubt that formation will complete itself but are always on the look out for potential trend reversals. The index may also be tracing out a larger head-and-shoulders pattern, which would have negative implications for both the index and the Nasdaq.

As the SOX has corrected, money has flowed back into the biotechnology stocks. Since 1999, there have been major rotations back and forth between these two industries, lasting multiple months. This certainly gives the aggressive trader opportunities to stay with high-beta stocks no matter what the overall market is doing. The AMEX Biotech Index (BTK.X ) broke out of an eight-month base in the middle of January and certainly looks much better from a technical perspective than the SOX.

The bond market rallied a bit this week with the yield on the 10-year Treasury note breaking slightly below the 4% level once again. Volatility is tightening like a noose around prices, and this usually suggests something major is about to occur. Being that we have been wrong on the direction of interest rates of late, fully expecting higher yields, we will wait until the market tells us which way the next trend will go.

Critical chart resistance for the 10-year lies in the 3.9% area, as this level turned out to be a bottom in yields in both October, 2003, and January, 2004. On the upside, important trendline support comes in at 4.27% with heavy chart support from 4.1% up to 4.7%.

The U.S. Dollar Index attempted to break out of a minor double bottom formation but was turned back. The index failed to clear the 88 level on Thursday, near the previous peak that occurred in mid-January, and then drifted lower on Friday. If the dollar index can close above 88, a measurable target up to 91 would be in place. Major trendline resistance lies up in the 92-93 zone and the 200-day exponential moving average is at 92.

We see the consolidation continuing for the stock market as the indexes work off their intermediate-term overbought condition.

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

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