The Summer Rally Is Here

Enjoy it while it lasts, though, as S&P believes further market weakness will be seen later this year

From Standard & Poor's Equity Research

A dramatic rally on Thursday, June 29, signified that the correction that started on May 10 has ended, in our view, and that the long awaited summer rally is here. With the build-up of bearish sentiment and extreme oversold conditions, a decent rally could be in store. However, we still believe further market weakness will be seen later this year, after the current rally runs out of gas.

The S&P 500 jumped 2.2% on Thursday, its best one-day performance since October, 2003. The Nasdaq had its biggest gain since March, 2004, soaring 3%, while the Dow Jones industrial average gained 2%, the best since April, 2005. Small caps did even better as the Russell 2000 rose 3.82%, the biggest rise since October, 2002, and the S&P SmallCap 600 jumped 3.4%, also the biggest since October, 2002.

Volume on the NYSE and the Nasdaq was above average and well above Wednesday's levels, giving us strong evidence that institutions were active in accumulating stocks. We also believe that there was a fair amount of short covering on Thursday, which can add fuel at the beginning of a rally.

With the strong advance on Thursday, the S&P 500 broke through trendline resistance, drawn off the peaks in May and early June, in convincing fashion. The index also broke back above its 200-day simple and exponential moving averages, as well as the 150-day exponential average and the 50-day exponential average. The rally took the "500" right back to its 65-day exponential average, which sits at 1271. The advance stalled right at the 50% retracement mark of the recent correction. A 61.8% retracement, another potential resistance level, lies at 1286. Chart resistance, from the small consolidation during the end of May and early June, is between the 1245 level and 1291. We think the current rally can carry up to the 1280 to 1290 range before some attempted profit taking will set in. There is another layer of chart resistance, from the trading during March, April, and early May, that runs from 1290 up to the recovery high of 1327.

The Nasdaq, which dropped 12.6% from Apr. 19 to June 13, also broke trendline resistance drawn off the recent peaks, but is in worse technical shape than the S&P 500, in our view. The Nasdaq is still trading below most of its key intermediate- and long-term moving averages, as well as below a fair amount of overhead supply, in our opinion. The 50-day exponential average lies at 2190 while the 80-day, 150-day, and 200-day exponential averages all sit in a very concentrated area between 2209 and 2223.

Chart resistance from the sideways action in late May/early June runs between 2136 and 2234. In addition, there is a thick layer of chart resistance from late last year and early this year that sits between 2190 and 2375. A 38.2% retracement of the correction is at 2184, a 50% retracement lies at 2220, and a 61.8% retracement comes in at 2257. We think that this initial rally can carry the Nasdaq up to the 2210 to 2230 zone before some more basing action takes place.

One indicator that is based on volume but is probably more of a sentiment indicator is the Nasdaq weekly volume divided by the weekly NYSE volume. This indicator is a good measure of market psychology, in our opinion. High Nasdaq volume in relation to NYSE volume represents periods of speculation as investors move towards the more volatile and more speculative stocks on the Nasdaq. Low levels of Nasdaq volume relative to NYSE volume occur during periods of fear, when investors move towards a defensive investment stance.

Over the last 5 years, the 3-day average of Nasdaq volume/NYSE volume has remained in a very definable range of 95% to 158%. This indicator gets oversold when it reaches the 110% to 95% zone. Rallies have occurred from this area. The indicator gives sell signals when it moves above the 140% level. At the end of last week, the indicator fell to 109%, just inside the buy zone. This indicator seems to reflect the times as it soared well above 150% during the late 1990s and early 2000, as trading in technology stocks was extremely heavy.

Treasury bond yields ran right up to the beginning of major chart support and reversed. The 10-year Treasury hit yield highs of 5.245% on both Monday and Wednesday, very close to the major support area between 5.25% and 5.50%. There was a big reversal Thursday, and yields continued lower Friday, finishing the week at 5.14%. Therefore, we think the recent breakout has failed. This factor, in conjunction with the negative divergences with respect to daily momentum indicators, along with the very overbought levels seen on the weekly momentum indicators may suggest that bond prices could be set up for a strong rally and that yields could see some downside pressure. Trendline resistance sits down at 5.05%, with chart resistance at 4.96%.

Crude oil had a strong week, rising over 4% to $73.93/barrel. This was the highest close since May 2. In the process, crude oil broke out of a triangle formation that started back on April 21. For a true price breakout, crude oil still has to take out the all-time closing high of $75.17, in our view. If this occurs, oil prices could run up to the low $80s area based on Fibonacci targets as well as analysis based on the width of the latest consolidation. Long-term trendline resistance sits in the $78 to $80 area.

Daily momentum has turned positive, a bullish sign in our view. Weekly momentum remains in an uptrend but has traced out one negative divergence. Additional weekly divergences, if they occur, would be a sign to us that oil is topping out from a long-term perspective.

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