Eroding Support for Stocks

Key technical levels on the major indexes failed to hold last week, making it more likely that they will test the July and October lows

By Mark Arbeter

While the major indexes appeared to do very little on a percentage basis last week, key technical levels on the S&P 500, the Nasdaq, and the Dow Jones industrial average failed to hold. This reaffirms our belief that more testing of the July and October lows will be seen.

The most important failure last week was the downside breakout by the Nasdaq below its 3-month trading range. The S&P and the DJIA had taken out their respective trading ranges the prior week. With the close below the 1319 level, the Nasdaq is now in the same position as the "500" and the DJIA, and unfortunately, has little chart support until the 1200 area, or the lows seen in July. The S&P 500 broke below an 8-day consolidation towards the end of the week and looks like it is headed to the 775 to 800 zone. The DJIA also broke down from a short-term consolidative pattern, with next chart support in the 7500 area, or the lows posted in July.

Obviously, many investors have moved to the sidelines due to the concerns over the geopolitical environment. The slow-motion decline is certainly not due to an abnormal level of selling, but just an absence of buying. What bothers us at this particular juncture is that it appears that many market participants are holding on to stocks in hopes that history will repeat itself and a quick fix to our overseas problems will emerge and stocks will subsequently blast off into a new bull market like it did in 1991. I wish market analysis was that simple and while history does repeat itself to some degree, one should be careful in making correlations between 2003 and 1991.

The most important difference is that the market is currently in one of the worst bear markets in history and the technical damage will not get repaired overnight. The overhang from the 1990s bubble could last years. In 1990-91, the market went into a correction/mini-bear market within the confines of a long-term bull market. Stock charts are in much worse shape today then they were in 1991. This is not to say that there will not be a positive response to military action somewhere down the line, we just don't think it will be long-lasting -- or represent the start of a multi-year bull market.

Also, market sentiment in the late 1990 and early 1991 period was extremely bearish, unlike today. From August, 1990, to February, 1991, Investors Intelligence showed more bearish investors than bullish investors for 26 straight weeks with a maximum bearish reading (bulls-bears) of -27.8 percentage points. During the latest attempt at a bottom, we saw two straight weeks in July and two straight weeks in October of more bears than bulls, despite the fact that the markets have fallen much further than they did in the early 1990s. The highest bearish reading over the last six months has been negative 14.8 percentage points. Clearly, the markets were in much better shape technically to begin a major advance in 1991 than they are today.

As we have said many times recently, low overall volume is quite typical of bear market action. There is little impetus to step up to the plate at the present time. We will also reiterate that our volume breadth models on both the NYSE and the Nasdaq are negative, and worsening by the day.

Another way to confirm whether money is flowing into or out of stocks is to look at the Money Flow Index, or MFI. The MFI attempts to measure the strength of money flowing in and out of a security or index. We like to use the MFI on the Nasdaq, looking for overbought/oversold levels and for divergences. During the Nasdaq rallies that have occurred during the bear market, the MFI has peaked out just above 75 prior to intermediate-term tops in the index, and will bottom out down near 25 or below.

The 21-day MFI peaked out in early November at 79 and has put in a series of lower highs and lower lows ever since. This indicator gave off a negative divergence when the Nasdaq went on to reaction highs in late November. The 21-day MFI is currently in the low 40s area so it has not yet reached oversold levels associated with intermediate-term lows of the recent past, suggesting further downside is certainly possible.

The number of new 52-week lows is rising, and this is another internal market measurement that has deteriorated enough to raise a caution flag. The percentage of new 52-week lows as a percentage of issues traded on both the NYSE and the Nasdaq has moved above 2.5%, after declining to almost nil. This is negative as it indicates that the number of stocks that have already taken out their July or October lows is rising. As the indexes approach their respective lows, it will be important from a technical standpoint that the percent of new lows does not rise above the levels seen in October of 13% on the Nasdaq and 18% on the NYSE.

Sentiment is certainly getting more bearish on a number of investment polls and also on the options market, but it has not reached an extreme. Some of the shorter-term market polls like Consensus, MarketVane and AAII are now showing much lower bullishness, but these polls have not yet moved far enough. The CBOE put/call ratios started rising this week, after moving to somewhat dangerously low levels.

While a back-up in sentiment will eventually be a positive, the switch from the bullish camp to the bearish camp sometimes marks the beginning of a decline and can sometimes indicate when a down move takes on some momentum. More pain is needed to fully push these sentiment indicators to bearish extremes, and we probably won't see a sustainable bottom until that occurs.

Arbeter is chief technical analyst for Standard & Poor's

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