Sounding the Bottom

Signs are building that a market low is approaching

By Mark Arbeter

The stock market continues its consolidative tone as the major indexes put in short-term bottoms on Monday, Mar. 15. As we talked about in our last column, the indexes had moved to an extreme oversold condition on a short-to intermediate-term basis.

We believe this created a perfect technical condition for the minor bounce that took place last week. Whether this bounce turns into something more substantial in the near-term remains to be seen but we do expect some further testing of the recent lows.

The rapid retreat by the S&P 500 during the second week of March pushed the index to its most oversold condition (daily basis) since the last major low in March, 2003. Incredibly, some technical indicators are as oversold as they were at the bear market low of October, 2003. Typically, extreme oversold conditions during bull markets are excellent, intermediate-term entry points. However, similar oversold conditions have frequently led to tests of the first reaction lows. This testing usually takes place over the near-to intermediate-term basis.

Recent readings from the 6-day and 14-day relative strength index or RSI on the S&P 500 can be compared to readings posted during the pullbacks and corrections that occurred in July, 1996, April, 1997, October, 1997, August-September, 1998, and August, 1999. In every instance, the S&P 500 either went back and tested the first reaction low or undercut this low on a minor basis, before resuming its primary trend higher.

A second rationale for believing a test will take place is that the 14-week RSI has not dropped to levels normally seen during these past declines. Weekly stochastics, after getting very overbought, have also not backed off enough to be confident that the final low is in.

Another indication that the market is oversold can be found by looking at the ARMS Index or TRIN on the NYSE. This indicator shows the relationship between the number of issues that are rising and falling in price and the volume that is going into both rising and falling stocks. If more volume is flowing into advancing stocks, the TRIN will be less than 1.0; if more volume is moving into declining stocks, the TRIN will be more than 1.0. The further the TRIN moves below 1.0, the more overbought the market is, and the further the TRIN goes above 1.0, the more oversold the market is said to be.

One way to look at the TRIN is to simply take a summation of the last five days. On Mar. 15, the 5-day summation of the TRIN hit 10.92, an extreme oversold level. This was the highest reading since the March, 2003 bottom. During bull markets, a reading of 8.0 or more has been seen at many intermediate-term lows.

Despite all these favorable technical conditions, the S&P 500 is likely to run into some decent resistance areas not far overhead and this should keep a lid on prices over the near-term. Chart resistance, from the bottom of the most recent trading range, begins in the 1,122 to 1,127 area. This is where the "500" ran out of gas at the end of the week. This piece of chart resistance runs all the way up to the recent highs of 1,160. The 50-day exponential moving average, now resistance, lies at 1,127, and the 20-day exponential moving average comes in at 1,131. A 50% retracement of the recent decline also gives a potential short-term target of 1,131.

Key support for the S&P 500 comes from a trendline that has supported prices since May, 2003, and lies at 1,114. This trendline is somewhat key to the index because it has been successfully tested three times and was nearly tested a fourth time. The more frequent a trendline provides support or resistance, the more important the line becomes. Key chart support is down at the recent closing low of 1,104.49.

The strength of the rallies, as measured by above-average volume moving into strong price action, will most likely foretell the next leg of this bull market, and confirm the end of the pullback/correction. There has been a clear pattern of distribution by institutions with respect to the Nasdaq since late January, and more recently on the NYSE. This can be seen on a daily basis as more volume is posted when the market heads lower, with less volume on positive days. This can also be backed up by the negative position of our accumulation/distribution models.

One way to monitor the volume dynamics of an intermediate-term advance is to look at the 10-day moving average of advancing volume divided by declining volume on the Nasdaq. During the initial stages of an advance, this ratio will rise sharply to at least 2.0, if not over 3.0. This usually marks the top for this ratio as institutions come back into the market in force. As the move gets older, this ratio will put in a series of lower highs. Eventually, there is just not enough fuel to push stocks higher and the indexes roll over, allowing the whole process to start over. This ratio will frequently dip below 1.0, sometimes approaching 0.5 as the correction deepens.

Currently, this ratio is slightly above 1.0 after falling to 0.78 during early February. What we would like to see to confirm a new advance is a spike back to or above 2.0. With the weak volume patterns of late, that has yet to occur.

Sentiment polls have backed off from their extreme bullishness, usually a sign that the market has entered a corrective phase. However, a couple of the polls such as Investors Intelligence still are heavily weighted towards the bullish camp with the latest readings of 52.5% bulls and 21.8% bears. The Consensus poll has seen a decline in bullishness from 81% in early January to 49%. The AAII poll has also corrected nicely, with bears rising to 34% from 10% in January.

The real move in market sentiment has occurred in the options market. The 10-day CBOE put/call ratio has spiked to 0.96 from 0.63 in mid-January. This reading is similar to the level seen at the bottom of the 1998 correction, which also was a period when the market was in a bull market.

While the green light has not been given to investors, and the consolidation is likely to continue, signs are building that a market low is approaching.

Arbeter, a chartered market technician, is chief technical analyst for Standard & Poor's