Hope at Last?

The market is due for some type of counter-trend rally. But don't get too excited just yet

By Mark Arbeter

The weakness in the Nasdaq has spilled over into the rest of the market the last two weeks like Niagra Falls. While the Dow Jones Industrials narrowly skirted joining the Nasdaq and the S&P 500 in bear market territory, that was little salvation to most investors.

The selling in most industry sectors, many of which have been performing pretty well recently, has been extremely heavy and swift. This "throw everything out of the portfolio" mentality reached a crescendo on Thursday, Mar. 22, and it appears that at least a short-term low is in. After almost two straight weeks of lower prices, there was a mini-capitulation on Mar. 22 with heavy volume and a big intraday reversal in prices. This type of action is at least constructive for the near term.

The declines in the S&P 500 and the NYSE over the last 10-day period are the worst since August 1998, while the 10-day price rate-of-change of the DJIA is the worst since the crash of 1987. In other words, the market has reached extreme oversold levels, once again, and is due for some type of counter-trend rally. What is interesting is that the price weakness into August 1998 was only the first low in a double bottom formation. The final low in 1998 came a little over a month later--which brings us to an important point: Even if the final low is in, the probability of some kind of test of the recent lows is very high.

Double bottoms are common market formations, and take time to develop, so there is no need to get aggressive. The market action at the end of the week was encouraging, but it is way too early to call for anything more than a short-term rally. There is still the "potential" for sub-1000 closes for the S&P 500 and sub-1500 closes on the Nasdaq. This past week, the S&P 500 held in a very good area of support between 1074 and 1133. The Nasdaq also held in a good support zone between 1775 and 1875.

Sentiment indicators continue to show improvement, but more is probably needed. The total CBOE put/call ratio has gone above 1.00 twice recently, the first time that extreme level has been reached since October. The 10-day and 30-day put/call ratios have moved to their highest levels since Oct. 1998. During the bear market in 1998, the CBOE put/call ratio registered eight 1.00+ readings, so it would be a plus to see more of these readings this time, in light of the severity of the market downdraft. What would be really bullish would be for the put/call ratios to move above 1.00, or to remain high, during an initial advance in the market. This occurred during the beginning stages of the market advance in 1995 and it would indicate initial disbelief that prices could possibly move higher now, given the severity of the recent decline.

Another sentiment indicator, the volatility index or VIX, finally moved above 40 on Thursday, the first reading above 40 since April. Once again, though, there were multiple 40+ readings on the VIX in the August to October 1998 timeframe. In fact, the VIX rose above 60 during the bear market in 1998. Market Vane, which measures the percentage of traders and investors that are bullish on S&P 500 futures, dropped to a bearish extreme of 21%, the lowest level in years. These sentiment indicators are showing that market participants are slowly becoming more and more pessimistic, a feature that tends to mark all major lows.

The TRIN or ARMS Index, which is the advance/decline ratio divided by the up/down volume ratio, has moved to an extreme oversold condition over the last week. This indicator measures whether volume is flowing into advancing stocks or into declining stocks. The extremely high readings of late indicate that the majority of volume is coming from stocks that are declining, another example of the "throw in the towel" mentality. The 4-day and 10-day TRIN on the NYSE have both moved to the highest levels since the market lows in October 1997.

With the market reaching extreme oversold levels and some sentiment indicators in the pessimistic camp, a short-term rally is a good probability. However, it is too early to call for a major bottom, and at the very best, the recent lows will be tested.

Arbeter is Chief Technical Analyst for Standard & Poor's