Bear Not Banished Yet

The market has not displayed the technical signals that usually accompany the start of a bull run

By Mark Arbeter

The short-term action of the stock market remains bullish and we see further -- albeit limited -- gains from current levels. However, sentiment has moved to an extreme level, suggesting a market pause. Additionally, we have not yet seen the characteristics typically witnessed during the late stages of a bear market and the early stages of a bull market.

The stock market pulled back during the middle of the week, and then resumed the uptrend on Friday, May 9. The pullback occurred on diminished volume, a bullish sign. The S&P 500 declined to trendline support and bounced sharply, which is also bullish. The "500's" drop was shallow, holding above its 10-and 20-day exponential moving averages. The one downside to an otherwise solid advance Friday was that the strong price gains were not accompanied by a commensurate level of volume.

While the market should be able to push higher, there is a confluence of resistance points for the S&P 500 that happen to converge near current levels. When a plethora of support or resistance levels converge, that usually means the market will have a tough time continuing its ongoing trend for long. The first piece of resistance lies at 938, and comes from a trendline drawn off the August and early December highs. There is chart resistance at 939, which was the closing high on Nov. 27, and additional resistance that runs up to 954 and represents the intraday high on Dec. 2. The next piece of resistance comes from the print low on Sept. 21, 2001 of 944.75.

The two most important pieces of resistance, and the ones that would suggest that at least a new cyclical bull market has started, lie up near 960. The bear market trendline, drawn off the "500's" peaks over the last couple of years, lies at 960. The August high or the top of the 10-month trading is at 963. If the S&P 500 can continue its rally up to this area, I would then expect a pullback, taking the index back towards the 875 to 900 area. There is good support here and it would represent a 50% retracement of the move off the March lows. If the decline occurred on light volume, and the market was then able to resume its bullish trend and break above the 960 zone on heavy volume, this would imply an end to the current trading range and probably healthy gains from there.

One indication that the technical conditions are strengthening during the current rally, vs. the rallies off the July and October lows is the improvement of many individual chart patterns. There are now many constructive looking bases that have developed over the past year and a nice increase in the number of new 52-week highs on both the NYSE and the Nasdaq. This chart improvement is characteristic of a market attempting to transition from a bear market to a bull market.

One longer term note: while there has been an improvement in chart patterns from an intermediate-term perspective, many stocks that continue to trade well below their respective peaks face an enormous amount of overhead supply, and this is one of the primary reasons that we believe gains will be limited looking out over the next few years.

There have been some mixed sentiment readings of late, but the balance of the tools we look at have moved to pretty bullish extremes. One bullish factor recently has been the action of the CBOE put/call ratios. During days when the market closes higher, there have been some healthy p/c ratios, suggesting that option investors do not believe this is anything more than a rally in a bear market. This is usually a pretty healthy condition and something that has not occurred during the entire bear market.

However, other sentiment indicators are flashing warning signs. We mentioned a couple of weeks ago that the AAII poll had moved to an extreme overbought reading. This week, Investor's Intelligence flashed a major sell signal. Bullish sentiment has increased to 55.8%, the highest in over two years. Bearish sentiment has fallen to only 24.4%, the lowest since December, 2002, right at the last intermediate-term peak. The ratio of Bulls to Bears has climbed to 2.29, the highest since early January, 2002. Whenever this ratio has climbed over 2:1, the market has either entered a long consolidative period or has seen a fairly healthy correction. What is interesting about this ratio is the fact that similar readings were seen after the Gulf War in 1991, and the market ended up in a sideways consolidation for the next nine months.

Over the last six months, we have written about the characteristics that have marked the end of most major bear markets and the subsequent characteristics that occur as the market transitions into a new bull market. From and chart perspective, the indexes trace out major, bullish reversal formations. In simplest terms, the market starts to put in a consistent pattern of higher highs and higher lows. Many new bull markets have started with a major double bottom formation. Currently, there is the potential that the S&P 500 is forming a rare triple bottom, which was last traced out to some degree in 1982. To complete this formation, the "500" would have to close above the 963 level.

The DJIA may be in the process of tracing out a reverse head-and-shoulders formation and would need a close north of 9050. At this point, we can't really characterize what formation the Nasdaq is attempting to trace out but would certainly be impressed from a longer-term perspective if the index could take out the interim high printed in early December of 1520.

Another indication that the bear has been put to sleep is the breaking of the major bear market trendline drawn off the major highs the last couple of years. For the S&P 500, this trendline comes in at 960, giving further importance to the highs of the current trading range. The Nasdaq has actually broken above its bear market trendline, suggesting that the worst is behind for the index. The early stages of most bear markets usually push many technical indicators into extreme overbought conditions on a short and intermediate-term basis. There are very high rate-of-change readings on a 50-day and 100-day basis.

There are very heavy levels of overall volume and strong upside volume statistics relative to downside volume as the bull market gets started. New leadership emerges from some types of growth stocks. Sentiment will reach extreme levels of bearishness at a bottom and stay there for many weeks if not months. And finally, a 5-wave advance takes shape, not the 3-wave advances that have been so common during the bear market. While it is still early in another attempt to break the back of the bear, none of these characteristics have occurred yet.

Arbeter is chief technical analyst for Standard & Poor's

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