Now Comes the Hard Part

The market's move higher has been impressive, but the rally looks like it's about to hit some serious resistance

By Mark Arbeter

The major averages have traced out bullish short-term bottoming formations, and considering the recent action has been positive, additional near-term gains should be seen. However, there is heavy resistance overhead, which could limit a major upside move for the intermediate-term.

The S&P 500's very compact (nine days from trough to trough) double bottom is likely to become part of a much larger bottoming pattern, perhaps tracing out an inverse head-and-shoulders. As we have said, major market bottoms take at least a month to form, and some bottoms have taken three to five months. One important point to remember, the longer (time) and wider (volatility) the bottoming formation, the much greater the potential and durability the next bull market will have. The mini head-and-shoulders bottom of the Nasdaq is also likely to be part a bigger formation, probably a wider head-and-shoulders.

The overriding positive though is the explosiveness of the rally off the bottom. The initial rally after a bear market is similar to the takeoff of a rocket ship. The heavy selling at the end of the bear market creates a vacuum and prices can advance quite easily at the start. The downside momentum in March was very strong as prices moved lower in a hurry, creating little resistance when the market turns higher.

Those easy, dynamic gains, however, are about to come to an end. The major averages are now moving close to areas that last witnessed heavy buying and represent formidable resistance. One way to identify potential resistance is to look for a very heavy volume day where most of the action was to the upside. The day the Federal Reserve first cut interest rates, Jan. 3, created a huge volume day on the upside. When the market fell below the prices seen on Jan. 3, the range for that day became resistance. All those investors that acquired positions that day ended up being very wrong and will now look to liquidate their losing positions as prices near and get into the range for that day.

Also, investors who participated in the January rally will look to cut their losses as prices rally. For the Nasdaq, the range of resistance from Jan. 3 is 2252 to 2618. The S&P 500 is in a similar situation, with heavy resistance from 1275 to 1348.

The other potential resistance for both the Nasdaq and the "500" comes from the downward sloping trendlines that have existed since September. These trendlines just happen to be near the lower levels of the ranges mentioned above. With chart resistance, heavy volume resistance and trendline resistance all coming in near the same area, the market will take time to eat through these levels. That suggests that the upside will most likely be limited over the next couple of months.

The danger exists, then, that a couple failed attempts in this area could turn a potential consolidation into something more significant. At worst, we could see a 33% to 50% retracement of the gains, but do not expect a test of the recent lows.

Up/down volume indicators for the Nasdaq remain in bullish modes, but their formation has been very jagged to the upside. This is quite different from many previous advances off of major lows, when up/down volume rose in a more orderly fashion.

This reflects the terrible chart condition of the major technology stocks. They rally for a couple of days, but then run into supply and back off. This action is likely to be the case for many months as the techs rebuild their charts. Most techs are way off their highs and therefore have plenty of resistance overhead, preventing any kind of sustainable advance.

Chart patterns on the 10-year Treasury are not favorable and we continue to be negative on bonds. The 10-year has traced out a small head-and-shoulders top which could turn out to be part of a much larger reversal formation. Yields have made little progress for months despite the plethora of weak economic news. The yield curve, which had been negative until very early this year, has steepened very quickly as the Fed has cut short-term interest rates while long rates have been stable.

This steepening suggests that the market believes that the easings will revive the economy eventually, which will not be positive for longer term rates. Long rates fell most of 2000, anticipating or discounting the weakness in the economy. When the economy improves, and with the expected longer term improvement in the stock market, rates have nowhere to go but up.

There could be some more short-term market gains, however, the intermediate-term outlook remains clouded due to the amount of resistance overhead.

Arbeter is Chief Technical Analyst for Standard & Poor's

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