Caution Flags for Stocks

Among the factors that could crimp the current rally: seasonal weakness and lack of robust volume

By Mark Arbeter

The major indexes continue to inch closer to very significant resistance areas that have acted as a ceiling since the beginning of the year. We believe the action over the next couple weeks will resolve the issue of whether the market can shake out of its pattern of lower highs and lower lows, or succumbs to another pullback or correction.

We continue to take a cautious approach to the stock market for a number of reasons. First, the market is in a seasonally weak period, with many major lows traced out during the months of September and October. Looking back at recent history, the market has put in fairly important bottoms during the fall months in 2002, 2001, 1998, 1997, 1994, 1992, and 1990. Along with this seasonal weakness, it must be noted that the market, as in other years, may be setting up for some additional downside in the form of some testing and basing action since there was already weakness into the mid-August low.

This leads to our second concern and that is on an historical basis, major corrective periods in the market are usually resolved with some type of reversal formation. Many times, this reversal is in the form of a double bottom, but can also be a head-and-shoulders bottom or a triple bottom. This pattern has yet to develop with any of the major indexes thus far, and in our opinion, it is worth waiting for some type of reversal pattern to emerge.

The third issue that we believe plagues the current rally is the lack of robust volume levels. Many intermediate-term and long-term reversals to the upside are accompanied by a flurry of activity as institutional investors pile back into stocks. While we have seen some decent volume during the latest rally, there has not been a rush to get back into stocks. Trading volume on the Nasdaq during recent advancing days has been running about 1.5 billion to 1.7 billion shares, while volume on the NYSE has been in the 1.1 billion to 1.3 billion share range. Compared to the volume levels during 2004 and 2003, these are not what we would consider the participation needed to propel the market into any kind of sustainable advance.

If the major indexes continue to rally next week, we believe they will all run into very critical trendline resistance that has contained prices this year. For the S&P 500, this resistance lies at 1,135. The Nasdaq has two important trendlines just overhead at 1,925 and at 2,000, while the DJIA will run into trendline resistance at 10,400. All of these trendlines are drawn off the successive peaks that were set earlier in the year. In addition, each index has moved into fairly heavy areas of chart resistance. The S&P 500 is currently trading in an area of chart resistance that runs from 1,120 to 1,160. The Nasdaq has strong chart resistance between 1,900 and 2,150, while the DJIA has tough chart resistance from 10,300 up to 10,800.

The VXO or volatility index for the S&P 100 moved to another new yearly low this week, and is now at the lowest level since the beginning of 1996. The VXO measures option premium levels and therefore is referred to as a fear gauge. The current VXO levels are well below the levels hit earlier in the year and can be considered at an area that represents extreme complacency. Each time the VXO has moved down to the 13 to 14 area this year, the market has either pulled back or moved into a correction.

Market internal measures remain mixed with most of the strength seen on the NYSE. The NYSE advance/decline line has moved to a new recovery high while the Nasdaq A/D line remains in a well-defined downtrend. The 10-day moving average of NYSE advancing volume divided by declining volume recently rose above 3:1, which is a strong reading, in our opinion. The latest reading actually exceeded the level that was posted during the rally in early June. On the other hand, the ratio of the Nasdaq's 10-day advancing volume to declining volume failed to take out the readings posted earlier in the year. The relative weakness in the internal measurements of the Nasdaq remains a concern to us, as growth stocks typically lead the market during sustained moves to the upside.

While we think the major indexes still have some room to move higher in the short-term, we still expect some type of pullback or corrective action over the next 4 to 6 weeks.

Required Disclosures

As of June 30, 2004, SPIAS U.S. research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings and 11.4% with sell ratings.

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company. SPIAS is affiliated with other entities, which may receive compensation for performing services for companies covered by Standard & Poor's Equity Research Services.


This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

Readers should note that opinions derived from technical analysis may differ from those of our fundamental recommendations.

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

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