A Tough Climb for Stocks

While there is some possible upside for the market in the near term, S&P remains cautious about the longer-term outlook

By Mark Arbeter

The major indexes pulled right back to their respective breakout points last week, but the bounce off these support areas has been somewhat anemic so far. With crude oil prices breaking down, we believe there is some possible upside for the market in the near term. However, we remain rather cautious about the longer-term outlook for the market.

Following the recent breakout from a small consolidation, the S&P 500 index fell back to the breakout point in the 1,165 zone. As we have said many times, tests of breakout and breakdown points are fairly common. The optimal setup, in our opinion, is a low volume test of this support, followed by a sharp price rise on heavy volume. Unfortunately, that's not what has transpired. The pullback to support occurred on a pickup in volume while the bounce has not been sharp, nor was it on higher than average volume.

If the stock market can come to life, the S&P 500 faces some potential barriers overhead, in our opinion. The 50-day exponential moving average lies at 1,173 with the 80-day exponential moving average at 1,175. Chart resistance, from the consolidation earlier this year, is in the 1,190 to 1,215 zone. The trendline that acted as support for the entire cyclical bull market is now resistance. This trendline is drawn off the March, 2003, lows and October, 2004, lows. The S&P 500 broke below this long-term trendline on Apr. 15, and therefore this line now represents resistance up at 1,195.

The Nasdaq dropped right to its breakout point of 1,962 and has also seen a fairly weak rally. If the test of support is successful, which is starting to look doubtful, in our view, our next target for the Nasdaq is chart resistance between 2,000 and 2,009. In our opinion, the Nasdaq remains the weakest of the major indexes, as it has not yet broken above its bearish trendline drawn off the March highs. That trendline lies up near 2,010. Four different intermediate- to long-term moving averages lie between 1,982 and 2,004, and also represent potential resistance for the Nasdaq.

Our concerns about the market from a longer-term perspective continue to mount. The first concern is the age of the current bull market. The cyclical bull market started in October, 2002, and is already over 2-1/2 years old. Typical cyclical bull markets last anywhere from two to three years. Even if the current uptrend can extend itself, the majority of gains occur early, so we believe the easy money has been made.

Secondly, there are some major cycles that are due to bottom during 2006. The first is the 78-week cycle low that is expected to bottom in February or March of 2006. The second and more important cycle (the four year) is projected to bottom out in the latter half of 2006. Many times, these four-year cycles come in during September or October. The last four-year low occurred in 2002, with others in 1998, 1994, 1990, 1987 (off a year), 1984, and 1980. Both of these cycles have been fairly accurate, so in our opinion, they bear watching.

Additionally, monthly or very long-term momentum indicators have either rolled over from very overbought territory, giving long-term sell signals, or are very close to rolling over. The monthly stochastic indicator based on the price action of the S&P 500 has turned down, giving a major sell signal. This is the first sell signal from the monthly stochastic since May, 2000. The monthly moving average convergence/divergence or MACD is close to crossing below its signal line for the first time since early 2000. Both the monthly stochastic and monthly MACD indicators have given major sell signals on the Nasdaq. Because these indicators are so long-term in nature, and give off signals very infrequently, we think it is a real eye-opener when they do.

The rotation into defensive stocks or late-cycle issues is the fourth reason for our long-term concern. Concurrent with the move into defensive issues is the absence of strong leadership from the growth areas of the market. In our opinion, growth stocks typically lead the strong parts of bull markets and we have not seen strength in this area since 2003 and 2004. Over the last three months, strength has come primarily from the defensive health care group, with minor strength seen in real estate investment trusts and utilities. These are not the kind of stocks that classically lead a bull market in the emerging stages, but are areas that lead at the end of a bull market.

Also, toward the end of most bull markets, the blue chip indexes tend to outperform the Nasdaq and small cap indexes. The Nasdaq topped out at the end of last year while the S&P 500 and DJIA did not turn lower until March. And finally, as we stated earlier, the major indexes have all broken below their respective bull market trendlines and are in danger of breaking long-term support from their 20-month moving averages.

Crude oil prices, after running up over $53 on May 10, reversed sharply and are now trading below important support at $50 per barrel. Crude prices finished at $48.54 on May 12, the lowest close since mid-February. With the break of the $50 level, the next level of potential support is in the $46 area. This support comes from a trendline off the lows in 2004 and 2005. The bull market trendline, drawn off the lows in 2001 and 2003, and therefore more important longer-term support in our opinion, comes in near the $42 level. With all the worries over surging oil prices by stock market participants recently, we are certainly perplexed by the lack of a positive reaction in the stock market.

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

Before it's here, it's on the Bloomberg Terminal.