A Rally Without Conviction

The Apr. 29 advance may have saved the market from further short-term damage, but S&P remains cautious

By Mark Arbeter

The major indexes tried to rally last week but the attempt to move higher lacked real conviction, in S&P's opinion, and the market subsequently rolled over, with some indexes falling to new lows for the year. The rally on Friday, Apr. 29, may have saved the market from further damage on a short-term basis, but we remain cautious from a long-term perspective.

In an effort to pick a market bottom, technicians first look to price and volume patterns. The typical price pattern at an intermediate-to long-term bottom is the double bottom. Other bottoming formations include a head-and-shoulders bottom [GLOSSARY] and a triple bottom.

After an initial bottom, there are a couple of characteristics I like to see to determine that a low might be in the making. The first is an initial price thrust that carries the market to some important resistance area. It is important that strong trading volumes accompany the rally. The next piece to a market low is a pullback to the initial low on a decrease in volume. Finally, another price thrust on heavy volume that carries the market past the first peak.

The rally off the initial low was weak from both a price and volume standpoint. The subsequent pullback then saw an increase in volume. The S&P 500 rallied right back to important resistance. On Monday and Tuesday last week, the index hit intraday highs in the 1,164 and 1,165 area, a key zone of resistance. The prior lows this year, and important chart support at the time, were in the 1,163 to 1,165 area.

In addition, the 20-day exponential and 200-day exponential moving averages also provided resistance in this area. As we have said many times, when an important support level gives way, it then becomes resistance. Many times there will be a kickback rally back to this new resistance level, and then a subsequent failure.

In addition to the key chart resistance up at 1,165, there are other pieces of key resistance not far overhead. Trendline resistance, drawn off the peaks in March and April, lies at 1,168, along with the 150-day exponential moving average. The 50-day exponential moving average comes in at 1,175 and the 80-day is at 1,188. On the downside, initial chart support lies at 1,137.50, or the closing low on Apr. 20. The next Fibonacci retracement of 61.8% of the rally from August until March would target the 1,125 zone.

From an intermediate-term perspective, the S&P 500 completed a double top formation by breaking the 1,163 area. According to technical analysis, the index now has a measurable downside target of 1,102.19. This target is calculated by taking the width of the consolidation between the 1,163.75 low and the 1,225.31 high. This width of 61.56 points is then subtracted from the breakdown point of 1,163.75 to get a measured target of 1,102.19.

The cyclical bull market started on October 9, 2002 with the S&P 500 at 776.76. We believe that the stock market is transitioning from cyclical bull to cyclical bear, all within the confines of a secular or long-term bear market. If the Mar. 7 peak at 1,225.31 turns out to be the ultimate high for the bull market, the S&P 500 rose 448.55 points or 57.8%.

If technical analysis is correct in indicating a bear market has started, we can use Fibonacci analysis to project the ultimate bottom and key levels where there may be support and counter-trend rallies. A 23.6% retracement of the cyclical bull market targets the 1119.45 level. A 38.2% retracement would take the S&P 500 down to 1,053.96, while a common 50% retracement of the bull market would target the 1001 level. A 50% retracement of the bull market would equate to an 18% decline. Using cycle analysis, the 4-year low is due in 2006, and many times this cycle low occurs in the third quarter of the year. Another important cycle low, the 78-week cycle, is projected to occur in the 1st quarter of 2006.

We believe the breakdown from a market internal standpoint confirms the weakness in the indexes. The NYSE advance/decline line broke an uptrend that has been in place since early 2003. The Nasdaq's A/D line has been falling since early 2004. The number of new lows has increased quite a bit on both the NYSE and the Nasdaq.

New lows as a percentage of issues traded on the NYSE started to rise in late January, and has been increasing ever since. From virtually zero in December, 2004, new lows/issues traded rose to 3% on Mar. 23 and to 5.4% on Apr. 15. The latter reading was the highest since last May. The latest reading on Apr. 28 was 4.1%. The Nasdaq has also seen its share of 52-week lows, hitting 7.2% of issues traded on Apr. 15. We believe that this increase in new lows is telling us is that the internal structure of the market is beginning to break down and that chart patterns are weakening.

The Nasdaq hit a new low for the year on Thursday, Apr. 28, slightly undercutting the Apr. 15 low of 1,908.15. A firm break of the 1,900 level would then target next chart support in the 1,750 to 1,850 area. The last major low for the Nasdaq was on August 12, 2004, at 1,752.49. On the upside, the index faces heavy resistance. Chart resistance begins in the 1,975 area and gets thicker right above the 2,000 level. Trendline resistance lies at 1,980 and 2,016. There is a host of key moving averages sitting up in the 1,990 to 2,010 range.

The Nasdaq has jumped 95.5% from its low on October 9 2002 of 1,114.11 to the recent peak of 2,178.34 on December 30, 2004. The index has already retraced 23.6% of that move. A 38.2% retracement targets the 1,772 level while a 50% retracement brings the index to 1,646.

We do not think everything is shaping up against the stock market. We believe the softness in the economy has brought both Treasury yields and oil prices down. While the market believes that the Federal Reserve still has more tightening to do, short-term market rates have started to pull back. Long-term rates have seen a big decline with the yield on the 10-year Treasury note falling from 4.7% to 4.2% over the last 5 weeks.

Crude oil, in our opinion, looks very toppy from a short-term perspective, and the break of the $50-per-barrel area on Apr. 29 could trigger some liquidation by the bulls. The next important support for crude oil lies at $45, with long-term support in the $38 to $42 area.

While it is possible to get nice countertrend rallies within a downtrend, we would remain on the sidelines until we see something that might be more than short covering.

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

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