Caution Flags for Stocks

Consistent weakness on heavy trading is a telltale sign that institutions continue to step back from the market

By Mark Arbeter

The major indexes broke down to new lows for the year last week and we see little evidence that the correction has run its course. Price and volume trends have been negative for most of 2005, the leaders of late 2004 have rolled over, and sentiment is still heavily tilted towards the bullish camp. While we continue to believe new recovery highs will be posted in the first half of 2005, we are maintaining our cautious stance towards stocks for the near-term.

The S&P 500 index marginally undercut the Jan. 13 closing low of 1,177.45 on Thursday, Jan. 20, and fell to its lowest closing level since the last day of November, 2004. Trading volume on the NYSE was 1.69 billion, well above average and the highest since Jan. 5.

The consistent market weakness on heavy trading is negative, and a telltale sign that institutions continue to step back from the stock market. Institutional investors have been pulling back all year and there is evidence that they have moved to more defensive areas of the market. Energy, health care, and food stocks seem to be the main beneficiaries of this rotation while Internet, software, networking, wireless, transportation and emerging markets have been hurt the most.

The "500" has fallen into an area of decent short-term chart support between 1,170 and 1,175. This support zone is from the trading lows from in November and December. The index remains below the key 50-day exponential moving average at 1,182 and could be headed for a test of the 80-day exponential moving average at 1,170. These moving averages frequently provide support for the market but when an index or individual stock falls below these averages, they can become formidable resistance.

A 38.2% retracement of the S&P 500's advance from October to December lies at 1,168.20. The next zone of chart support is between 1,140 and 1,160, or the peaks in the rallies during 2004. A 50% retracement of the advance targets 1,154 and the 150-day exponential moving average comes in at 1,150. As we have been saying, there are a lot of support levels underneath current prices.

Last week, the Nasdaq composite index fell to its lowest level since Nov. 10, breaking short-term chart support on Thursday, Jan. 20, at 2,070. The manner in which the Nasdaq broke support adds to our cautiousness. The index gapped lower on Thursday and closed at its low for the day. In addition, volume was higher than average, and from a short-to intermediate-term basis, this type of action is negative in our opinion.

The Nasdaq is now well below its 50-day exponential moving average and also broke below its 80-day average. This is the first time that the Nasdaq has been below the 50-day for multiple days since back in July. The next piece of support comes from a 38.2% retracement of the rally from August until December, and this targets the 2,016 level, while a 50% retracement lies at 1,965. The 200-day exponential moving average comes in at 1,994 with another layer of chart support at 1,970. Long-term trendline support lies at 1,950.

Internal market data continues to weaken, as this has been a pretty broad-based selloff. The NYSE advance/decline line has broken its intermediate-term uptrend that has been in place since August. The long-term uptrend for the A/D line remains intact. This long-term trendline is drawn off the March, 2003, low in market breadth and is formed with the A/D lows in May and August, 2004. The Nasdaq A/D line has also broken an intermediate-term trendline and is in a very steep decline. Volume breadth or the difference between advancing and declining volume on both the NYSE and the Nasdaq has been negative since the start of the year. The 10-day summation of advancing volume minus declining volume recently moved to its most oversold condition since August, 2004.

Sentiment polls continue to reflect a high degree of bullishness and we believe this is something that might have to change before a bottom can be put in. The Investors Intelligence poll of newsletter writers has backed off a bit and is now showing 55.9% bulls and 24.7% bears. The MarketVane poll is 63% bulls while the Consensus poll is still 72% bulls.

Put/call ratios on the CBOE are rising but are not yet at levels that are normally associated with enough pessimism seen at market lows. The 30-day exponential moving average of the CBOE put/call ratio has risen from 0.75 in December to 0.83. In October, this measure of market sentiment hit 0.92 and in June, it spiked to 0.98. One area where sentiment has gotten very pessimistic is odd lot short selling on the NYSE. There have been four days in January with odd lot short sales over 2 billion shares, which is way above average. Oil futures pulled back during the week before rallying sharply on Friday, Jan. 21. The pullback looks like a test of the breakout point in the $46-per-barrel area. Chart resistance lies up at $50 and if this level gives way, oil could be heading for an important test of the all-time highs up at $55. Weekly momentum has turned and may give a buy signal over the next week or two. The weekly momentum went negative in the middle of November after being bullish since July. We believe another spike in oil prices could keep pressure on equity prices over the near-term.

The weakness early this year has caught many by surprise, including us, but we have learned not to fight the tape or the action of the market. We believe a cautious stance is warranted and will wait for the market to tell us when it is safe to plow back into stocks.

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

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