The Market Digs In

The major averages held key support levels last week. But a re-test of the March-April lows may be necessary for a rally

By Mark Arbeter

In a week of heavy second quarter earnings disappointments and negative forecasts about the third quarter and beyond, the market stood tall and held its ground. The S&P 500 and the Nasdaq both held near their respective lows set on July 11 and moved higher late in the week.

However, despite the change in near-term momentum from negative to neutral, the short-term chart picture still looks negative as the indexes have not yet pushed above downward sloping trendlines that have existed since the May highs. For the shorter term chart picture to turn bullish, a close above 2105 on the Nasdaq and 1225 on the S&P 500 would be needed. This would break the string of lower highs for the indexes and would also punch the indexes through trendline resistance.

From an intermediate-term perspective, and more importantly, the Nasdaq and the S&P 500 have not yet cracked through critical support created by the heavy volume day on Apr. 18. The price ranges during heavy volume days are very important support/resistance areas because so many shares traded within that range and therefore market participants have a high vested interest in that price area. The huge rally that day was caused by the surprise rate cut by the Federal Reserve, and remains the second heaviest volume day in history.

The key levels that must hold continue to be 1923 for the Nasdaq and 1180 to 1192 on the "500". These are crucial because if the market slides below them by a couple percent, the ranges set on April 18th then become resistance and the potential rises that increased selling pressure would hit the market, forcing stocks down for a retest of the March/April lows.

While a test of the Spring lows would be painful for investors, it would be very normal and quite positive for a number of reasons. The major market bottoms of 1973-74, 1982, 1990-91, and 1998 were all double bottoms, except 1990-91, which was a head-and-shoulders bottom. So a retest in the next couple of months would set the stage for a very normal chart pattern (double bottom) usually seen at major lows. It would also set the stage for a very wide base of about five to six months. Bigger bases are also more common at major lows, and the wider the base, the better its potential for gains.

A decline back to the March/April lows would also alleviate some of the bullishness seen in some of the sentiment polls and would probably create extreme bearish readings in other polls and option ratios. In the last couple of weeks, bearish sentiment on the Investors Intelligence poll of newsletters was at its lowest level since April 1998, while bullish sentiment was fairly high, not something one would expect to see at a major bottom. One other positive of a successful test would be that it would show that long term money is coming into the market at a similar level as before and would suggest that these investors feel very comfortable stepping to the plate at these prices. In one important sense, the formation of a bottom is the process of transfering stock from weak hands or those with major losses, to stronger hands or those who have been out of the market and have been patient as valuations have come down.

One constant and frustrating fact of the current transitional market phase is that leading stocks from a relative strength basis continue to fail. Many stocks have attempted to break out, only to come crashing back to their bases. When upside breakouts start to hold, it will be a good indication that some new leadership is emerging, something sorely missing in this market.

One interesting aspect of the bottoming phase is that a number of higher volatility indexes are starting to complete what could be head-and-shoulder bottoms. These indexes include the Philadelphia Semiconductor Index or SOX, the Amex Biotech Index and the Russell 2000 Index of small cap stocks. While these formations are not complete, it may be an early sign of some developing leadership.

The timing of a possible retest of the lows would most likely occur during the months of September or October. Historically, there have been more major lows in October (1998, 1997, 1992, 1990, 1989, 1987, and 1974) than any other month. The weakness in the Fall, due mostly to tax loss selling, is very common. Because both the Nasdaq and the S&P 500 are below where they started the year (Nasdaq: 2470.52, S&P 500: 1320.28) and way below the levels seen in 1999 and 2000, tax selling could once again be fairly heavy. An October bottom would set the market up for a strong rally during the seasonally favorable months of November, December, and January.

Arbeter is Chief Technical Analyst for Standard & Poor's

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