Holding the Line

Last week marked an important low for the markets. But near-term upside is limited

By Mark Arbeter

While the major indexes are still in short-term downtrends, the turnaround in stocks late last week enabled the Nasdaq and the S&P 500 to hold at critical support levels.

The indexes have put in a series of lower lows and lower highs so the short-term trend remains lower. Despite the strength on Thursday and Friday, the S&P 500 and the Nasdaq did not break above the basic downward sloping trendline which is drawn off the intraday high on May 22. Resistance from these trendlines comes in around 2125 for the Nasdaq and 1220 for the S&P 500.

The small head-and-shoulders formations on the major indexes still exist although the minimum downside target for the S&P 500 was fulfilled when the index fell to the 1180 area. The Nasdaq has yet to fulfill its downside target of 1850 because major support came in which we will address shortly. The recent corrections were typical with the "500" retracing about 61.8% of the move from March to May while the Nasdaq retraced 50% of the move from April to May.

Because of the late week rally, the critical areas of support (mentioned in last week's comment) created by the heavy volume day of Apr. 18 held. The levels that were important to us were 1923 on the Nasdaq and 1192 on the S&P 500. While the "500" did close marginally below this level, we had mentioned that for trouble to develop, the index would have to finish under 1192 by a couple percent. The Nasdaq fell to 1934 intraday on Wednesday and then reversed strongly.

If these levels eventually give way, we feel a test of the March/April lows would be a high probability. While that scenario would definetely scare a lot investors, it would set the market up for a fairly broad double bottom and most likely be a nice launching pad for the market. Historically, bottoming formations after severe drops have taken three to five months to develop and the market is now in its fourth month, so whether we test the lows or not, the market should be getting close to its final low. This obviously assumes that the initial low in March/April started the bottoming process (which we believe) and that those lows will not be taken out by a substantial margin on a retest.

One positive that is continuing to unfold is that many of the major technology stocks that bottomed in April, have so far held above those lows. Along with that, there has not been a very big expansion in the new low list on the Nasdaq during the latest correction. Heavyweight technology stocks such as Cisco (CSCO ), Intel (INTC ), and Sun Microsystems (SUNW ), which all hit lows in April, have all held above those lows. On the negative side, there have been a fair number of tech stocks such as Ciena (CIEN ), Comverse (CMVT ), EMC Corp. (EMC ), and Solectron (SLR ) that did make new lows during the latest correction. It is critical that the major techs hold above their recent lows or the likelihood increases that the major averages will retest their March/April lows.

Sentiment is mixed despite the recent correction. The Consensus Poll (short-term) has done a complete turnaround, with bullish sentiment down to 27% from 66% in May. However, a longer term measure of sentiment, the Investors Intelligence poll, is still showing a fairly bullish slant. Bulls are at 51% while bears have dropped to a very low 25%. Bearish sentiment is the lowest since since July 1999, which marked an intermediate-term top for both the "500" and the Nasdaq.

Other measures of sentiment, including CBOE Put/Call ratios and Volatility Indexes have been rising but have not moved to levels normally associated with major lows. For instance, the 10-day CBOE P/C ratio recently hit 0.77, below the 0.89 level it reached in March. The 30-day has climbed to 0.70, still below April's level of 0.78. The VIX, which is a measure of option premiums on the OEX, rose over 28 on an intraday basis this week, but is well below what is normally seen (+40) at bottoms. The VXN, which uses option premium levels based on the Nasdaq 100, climbed above 60 during the week, but that is well below 80 which was seen in April.

The market remains extremely tentative and we at S&P believe it is still vulnerable to further downside action. Even if last week marked an important low, we continue to believe that the upside is capped for the near-term.

Arbeter is Chief Technical Analyst for Standard & Poor's

    Before it's here, it's on the Bloomberg Terminal.