A Brief Move Higher

Short-covering rallies typically last one to four trading days -- and then prices lose upside momentum

By Paul Cherney

I cannot call Tuesday's action anything other than a short-covering rally. The total trading volume was good and I think there has been some money coming in off the sidelines, but still, short-covering rallies typically last 1 to 4 trade days, then prices lose upside momentum and retrace. It is the nature of the retracement which will offer the best clues as to whether we are the beginning of a move higher which can last for more than 2 or 3 days.

Basically, I would be looking for an ABC pattern (in the end-of-day price bars) to signal increased odds for a more protracted move higher. This initial lift from the lows represents the move from Point A (the low), to Point B, the potential bullish break-out point. We do not know what Point B is yet. It may have been set today, it may be set tomorrow, we have not seen the B to C retracement yet (I am referring to daily price bars here).

Today's price action has confirmed the significance of the resistances for the indexes: the Nasdaq's focus of resistance is 1696-1718, and the S&P 500 has immediate resistance 1082-1096.77. If either index were to be able to move above these levels, and close there. They would be converted to immediate support levels. (Doubtful, but I cannot rule it out right now.)

The Nasdaq's immediate intraday support is 1681.57-1673.67. The index has a broader band of support 1673-1626.99 with a focus 1663-1650.

I would be reluctant to embrace the first rebound in prices as the beginning of an uninterrupted trend higher. Why? Investors are still worried about problems with earnings/valuations, accounting practices, and the nature of the current economic recovery (double dip?). I have end-of-day indicators based on price and volume which have hit levels which usually signal that a rebound in prices, even one that lasts 2 to as many as 4 trade days, will run out of momentum and prices usually return to test the price range on the day the short-term lows were set. It is rare when these indicators are in their current configurations that the markets can just turn on a dime and head higher without looking back.

The Nasdaq's resistance is really a broad layer between 1674-1728.52 but there is a particularly thick layer of price action in the 1697-1718 area. The next layer of resistance is 1736-1763.

Immediate S&P 500 resistance is 1082-1096.77 with a focus 1088-1093.18. The index has thick resistance at 1103-1133.31 which should rebuff a first assault.

Glossary: Short-covering rally. A short-covering rally is marked by a reversal of a trend lower in prices. The rebound in prices usually sees a step-up in trading volume. In my opinion, the phenomenon is fueled by by 3 factors: 1)bears covering short positions to book profits, 2) momentum players jumping on the backs of their bearish brethren, increasing the pressure on bears to salvage profits by buying back rising stocks, 3) some longer-term investors (bargain hunters) stepping to the plate.

The buying demand of the bears covering shorts is a short-term event, their buying demand probably does not last more than a day, maybe a day and a half. The momentum players (short-term traders who buy into the advance in prices caused by the short-covering) are probably willing to take profits after the first day of the rally, but since they are momentum players, most of them will probably hold onto their long positions until it is obvious that the momentum for higher prices is over. If the longer-term investors are not convinced that there is some sort of relative value in equities then there will be no one to support prices and the retracement after the intial short-covering lift will undercut the lows at the start of the short-covering.

Before 1997, I normally expected short-covering rallies to last 1 to 4 trade days with 4 trade days a good bet for successive gaining sessions. Things have become a little more erratic over the past 4 years. But it is usually the 3rd or the 4th trade day when prices can simply run out of buyers. The S&P often times will hesitate, its trading range will contract (the difference between the high and the low of the session) to less than the price ranges of the initial short-covering rally days, and often, there will be a day that the index posts just a minor gain or loss as the momentum players become convinced that staying in the market in the short-term is only going to eat into profits.

Cherney is chief market analyst for Standard & Poor's

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