Time to Get Defensive

Stubbornly high oil prices are finally starting to take their toll on the stock market

By Mark Arbeter

The stock market made a clear break to the downside last week as crude oil prices surged to another record high. With the historically weak months of September and October looming, and a poor technical backdrop, we at Standard & Poor's remain in a defensive mode with respect to equities.

In our view, the persistently high price of oil is finally starting to take its toll on the stock market. Crude oil prices have remained above $60 per barrel since the end of July, and climbed to a closing record of $67.49 on Aug. 25. The surge in crude oil on Wednesday, Aug. 24, took its toll on the stock market as some of the major indexes broke key short-term support levels.

What is particularly worrisome to us is that it appears that investors are starting to shy away from economically sensitive stocks, due to concerns about oil, and are moving towards a more defensive posture. Some of the leaders during the last 6-12 months have rolled over, and many of these issues are considered growth stocks. Historically, when the leaders start heading lower, the overall market becomes vulnerable. Readers should note that past performance is not necessarily a valid indicator of future results.

During the last couple of weeks, there has been a very distinct breakdown in many economically sensitive subindustries. Many retailing stocks have rolled over with weakness also seen in chemicals, homebuilding, advertising, steel, aluminum, forest products, and construction materials. Investors have been rotating some funds to the oil sector, but have also moved into agricultural products, utilities, tobacco, and distillers and vintners. These are traditional areas of the market that usually benefit when investors are concerned about the market.

The S&P 500 broke key short-term support in the 1217 area on Wednesday, and the pattern of lower highs and lower lows is still in force. From the close on Aug. 16 to the close on Aug. 23, the index finished in an extremely narrow range of four points. We believe the S&P 500 traded in this tight zone for so long because there was an abundance of support that was very close together. The 50-day exponential moving average, chart support, as well as trendline support all came together to provide support at this point. With the breakdown on Wednesday, this area now becomes important, short-term resistance.

The next concentrated area of support for the index lies between 1183 and 1205. Chart support, from the small consolidation in June and July, occurred within these two levels. The 150-day exponential moving average is at 1198; the 200-day simple lies at 1195 with the 200-day exponential average at 1190. A 38.2% retracement of the rally from April to early August targets the 1204 level while a 50% retracement of the recent rally targets 1191. Intermediate-term trendline support, drawn off the August 2004 and April 2005 lows, comes in around the 1190 area. So at the very least, the 1183 to 1205 range should, in our opinion, provide some support for the index during the current pullback or correction.

Technical indicators based on daily prices have moved to an oversold condition, suggesting the possibility that a countertrend rally could take place over the next week or so. The 6-day relative strength (RSI) indicator fell to 25 on August 24, equaling the level hit during the pullback in late June. The daily stochastic oscillator has fallen to its most oversold level since April, which was the last intermediate-term bottom. However, weekly technical indicators are in far different position, and in our opinion, it is not pretty. The weekly stochastic oscillator has rolled over after getting overbought, and has issued an intermediate-term sell signal.

In our view, the weekly moving average convergence/divergence (MACD) indicator is in danger of giving another sell signal. The weekly MACD has traced out a series of lower highs since the beginning of 2004, putting in place numerous negative divergences. The last series of weekly MACD divergences occurred during 1998, 1999 and early 2000. The 14-week RSI is not even close to being oversold, and has also traced out a pattern of negative divergences. So while we could see a short-term bounce, the intermediate-term picture remains decidedly bearish to us.

The recent action, in our view, continues to worsen, as more evidence mounts that institutions are on the one hand, rotating to more defensive groups, and on the other hand, lightening up on their stock holdings. Wednesday's intraday reversal was nasty, and continues a pattern of intraday rallies that fail. In addition, weak market days continue to be accompanied by an increase in volume, while rallies have taken place on light volume. Our accumulation/distribution models on the NYSE and the Nasdaq remain in bearish configurations, and we believe this will lead to further downside action.

Market sentiment is starting to back off from its extreme bullish levels, and eventually, we think this will be good for the market. However, when market sentiment gets extremely bullish, and then starts to turn more cautious, that is usually when the market heads lower. It is not until sentiment has moved to the bearish side of the fence, in our view, that we can expect a potential market bottom. When the majority of investors are bullish, they have only two options: hold on during a decline or throw in the towel and sell. Intermediate-term market lows usually occur when the majority of investors have thrown in the towel. Unfortunately, that will take some time and lower prices in our view.

While crude oil has been blamed for some of the recent weakness in the stock market, we are actually looking for a correction in oil prices over the next couple of months. There is a seasonal pattern of weakness in the fall for the overall stock market as well as for oil prices. It will be interesting to see if there can be a concurrent correction in stocks and oil prices. Remember, for the last couple of years, stocks have risen along with rising crude oil prices. Why can't they both go down during the weak seasonal period that is just around the corner? Crude oil prices hit an all-time closing high of $67.49 last week, slightly exceeding the peak in mid-August. Crude oil is up a whopping 44% since May 20, and we believe some profit taking is overdue. Both daily and weekly technical indicators are very overbought, suggesting that a pullback or correction could take place, in our view. Near-term trendline support lies at $63, with decent chart support down at $57. Long-term trendline support comes in around $50.

Since peaking at 4.42% on August 8, the 10-year Treasury bond has rallied nicely, and finished the week yielding 4.19%. The 10-year has moved back to chart resistance that starts in the 4.19% zone. The bond has also retraced about 50% of the move from June to August. We believe some of the recent strength in bonds has come at the expense of the stock market. When investors get defensive, one area they frequently move to is bonds. Sentiment towards the bond market has once again moved to fairly bullish levels, with MarketVane showing 70% of traders in the bullish camp. While bonds could benefit from further weakness in the stock market, we think that with sentiment already so bullish, yields could reverse and head higher once again.


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Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.


As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

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

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