The Market Rolls Over

Stcks have entered their weakest season of the year, and S&P thinks some caution is warranted

By Mark Arbeter

The stock market started to roll over last week and we believe equities have entered their first decent-sized pullback since March. The market has entered the weakest seasonal time of the year, and we think some caution is warranted over the next month or two.

The latest rally pushed the S&P 500 up to the 1245 level, very close to some key pieces of resistance. We have found that when there are a multitude of support or resistance pieces close to one level, it is very difficult for the index to move through these areas, especially on the first test. The first key piece of resistance is 1253 and this represents a 61.8% retracement of the entire bear market. In addition, a major chunk of chart resistance, from back in 1999 and 2001, begins in the 1260 area. Third, there is a long-term trendline, drawn off the lows in 2003 and 2004 and was once support, that comes in at 1250. Fourth, a trendline drawn off the peaks in 2004 and 2005 lies in the 1260 zone.

In combination with so much resistance just overhead for the S&P 500, the market is entering its weakest period on a historical basis. Many mid-summer market peaks are followed by selloffs in August, September and into October. Just looking back to 1990, there have been either a minor or major low in 2004, 2002, 2001, 1999, 1998, 1997, 1994, 1992, and 1990. There is a very consistent pattern of weakness during the late summer/early fall months, and we believe this factor should not be ignored.

At this point, we do not see major damage during the next couple of months, but do see the S&P 500 pulling back about 5%. Immediate chart support for the "500" lies in the 1217 to 1225 area. This range of support comes from the recent highs in the index during March and June. Trendline support, off the lows in May and July, lies at 1225. Longer-term support, drawn off the lows in 2004 and 2005, comes in at 1180. The lows from June and July lie in the 1180 to 1190, and represent a potential area of chart support. Longer term and more significant chart support is in the 1137 to 1165 range, as this zone represents the important market low from April.

The Nasdaq has led the way to the downside, having dropped over 3% since peaking on Aug. 2 at 2218.50. The index's most recent peak was at the top of a mildly rising wedge that has formed since the beginning of 2004. Many times, these formations are bearish, and end up breaking to the downside. When the Nasdaq was above 2200, it was also dealing with chart resistance from back in 2001. On the downside, the Nasdaq does not have significant support until down in the 2100 area. While the 50-day exponential moving average lies at 2129, the fact that the Nasdaq raced up from 2100 to 2200 leaves little chart support in between. There is a nice zone of chart support in the 2000 to 2100 area. The 200-day exponential moving average comes in at 2054 while trendline support, off the 2004 and 2005 lows, lies at the 2000 level.

Weekly stochastic oscillators on both the S&P 500 and the Nasdaq had moved to very overbought conditions during the latest rally, and are now rolling over, suggesting that additional weakness is possible over the next month or so. In addition, the weekly MACD failed to confirm the strength in the major indexes, and has traced out a series of lower highs since the beginning of 2004. These negative divergences are usually not positive for the market and also suggest to us that more downside action is possible.

In addition, there has been some deterioration with respect to internal market measurements. New lows divided by issues traded on the NYSE has begun to move higher after being very well behaved over the last three months. A timing model we use, which plots the 20-day exponential moving average of new NYSE lows and the 60-day exponential moving average of new lows, is close to turning bearish for the first time since late February. There has also been a sharp deterioration in the 10-day average of NYSE up/down volume over the last couple of months. This indicator, like many, usually gives off multiple negative divergences as a price advance ages, and that is exactly what is happening once again.

Market sentiment is another reason for our caution. The sentiment polls we follow have all moved to extreme bullish levels, and from a contrarian view, this eventually is bearish for the stock market. Investor's Intelligence poll of newsletter writers is showing 59.1% bulls, the highest level since early January. Bearish sentiment has dropped to only 19.3%, very close to the lowest level since June 2004. The difference between bullish and bearish sentiment is currently 39.8 percentage points, the widest spread since late December 2004. The combination of two short-term polls, Consensus and MarketVane, is also at the highest level of bullish sentiment since December 2004.

Crude oil prices surged to another record high last, rising about $4.50 per barrel to $66.80. Oil prices are now up an incredible 43% since late May. With crude oil above our target of $65 and with momentum strong, we see the possibility that prices could run up near $70 before correcting. Like the stock market, crude oil prices tend to gravitate towards big round numbers. Once this intermediate-term rally runs its course, we still expect a decent correction to occur.

In addition to the quick price jump since May, the 14-week relative strength index is once again approaching an extreme overbought condition of 70. The last couple times the 14-week RSI as either approached or exceeded 70, the price of crude corrected. Near-term chart support lies at $57 with trendline support down in the $50 area. Despite our call for a pullback in crude, at this point we believe it will be just another correction within the ongoing bull market.

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

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