Clouds on the Horizon

The rally in stocks could run into resistance in the intermediate term. Here's why

By Mark D. Arbeter

The stock market's performance last week was impressive, as a couple of major indexes broke out to new recovery highs. On Wednesday, the S&P 500 and the Dow Jones Industrial Average both completed head-and-shoulders formations on a big increase in volume. The "500" moved to its highest level in three months while the DJIA broke to an eight-month high. Prior to the strong moves this week, the consolidation which took place was bullish because it occured on very light volume. The Nasdaq, while up more sharply from the recent April lows versus the other indexes, has yet to break out to a new recovery high above 2233.

While the price patterns of the indexes are positive, our bullishness continues to be tempered by the amount of overhead supply the market must now deal with. The S&P 500 broke through the bottom of this resistance zone which starts at 1275 but this supply runs all the way up to 1350. Also, the index has failed to concisively break through the basic downward sloping trendline that has held prices in check since September 2000.

A minor pullback to the breakout point of 1270 on light volume would be bullish and set the stage for a another run higher. The subsequent rally should see a pickup in volume or doubts about its potential will arise. A test of a breakout point is quite common and usually represents the final shakeout of weak holders.

It appears the Nasdaq is still in the process of completing a major reversal pattern and needs to play catch-up with the other indexes. The Nasdaq has also failed to definitively break above resistance provided by the basic trendline drawn off the September 2000 high. Major chart resistance begins at 2250 and that level also represents about a 50% retracement of the late January to early April decline.

The "500", the DJIA and the much broader NYSE are in much better technical shape than the Nasdaq from the perspective of chart patterns. The strength in these indexes can also be demonstrated by looking at which sectors are acting the best as well as by looking at the chart conditions of the major technology stocks.

Leading sectors include oil & gas, engineering and construction, independent power producers, retailers, utilities, tobacco, long-term care and some health-related stocks. These are mostly S&P 500/NYSE type stocks, not the kind found on the Nasdaq. The charts of almost all technology stocks are very similar. They are all well below their respective highs, trading in sideways patterns, and have yet to break out of these formations. Our point is that the strength remains in the more value oriented sectors and that the performance of the Nasdaq is not likely to lead for some time to come.

Bonds remain susceptible to further weakness after recently completing a head-and-shoulders reversal pattern. Adding the height of the reversal pattern (70 basis points) to the breakout level gives us a yield objective of 6.1% for the 10-year treasury. The 10-year also broke a bullish trendline that has supported the market since last May. Yields on the 10-year are now at their highest level since December 2000.

The stock market is at an important juncture, with the easy gains behind us. The market must now deal with the heavy supply left over from the January rally. While the short-term trend is definitely higher, the intermediate-term trend is still in question and will not be resolved to the upside until a majority of the overhead supply is worked through. At this point, a staggered move higher will most likely take shape over the next couple of weeks to months.

Arbeter is Chief Technical Analyst for Standard & Poor's

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