Caution Flags for Stocks

Price and volume measures are fading, and a key cyclical index is looking weaker. Another bad sign: The breakout in gold prices

By Mark Arbeter

The stock market consolidated its recent gains last week as the uncertainties relating to Hurricane Katrina and a big Federal Reserve meeting on interest rates Sept. 20 raised some anxiety among investors, in our view. Technically, the S&P 500 index and the Dow Jones industrial average ran into some near-term chart resistance last week, so we believe a pause in the rally was not totally surprising. Bond yields surged last week while gold prices rose to their highest level since 1988.

The S&P 500 closed the week before last at 1241.48, getting very close to the early August closing high of 1245.04. While the pullback last week was mild, it did occur on above-average volume, and therefore, raises some doubt about a big move to the upside in the near term, in our view. NYSE volume was up around 1.5 billion shares on Tuesday and Wednesday of last week, days in which the market was weak. This compares to the 50-day average of trading volume of 1.4 billion.

On Wednesday and Thursday, the S&P 500 found support from its 20-day exponential moving average around the 1227 level. There is a host of other near-term support levels including the 50-day exponential moving average at 1222, trendline support at 1208, and chart support down at 1200. Longer-term moving average support lies in the 1195 to 1203 area.

On the upside, key intermediate-to long-term resistance lies up at the 2153 level. This represents a Fibonacci retracement of 61.8% of the bear market from 2000 to 2002. Secondly, trendline resistance drawn off the peaks in January, 2004, December, 2004, March, 2005, and August, 2005, comes in right at 1253. This is obviously a key trendline because it has capped all rallies over the last 20 months, and provided a real ceiling for the S&P 500.

Since the market low in April, each rally has occurred on a decline in momentum on many fronts. This is typical as a rally ages and this can also be seen since the cyclical bull market began back in October, 2002. The first peak in prices off the April low took place in June, with the second peak in early August and possibly the third peak just the week before last. The 6-day relative strength index or RSI rose to 81 in June, 77 in July, and 72 in September. The 14-day RSI hit 67.5 in June, 67 in July, and only 61 so far in September.

Looking at a longer term view of the RSI chart, the 14-week RSI peaked in January, 2004, and has put in successive lower highs ever since. This can also be seen in the weekly moving average convergence/divergence (MACD) chart. This pattern of decreasing momentum can also be seen with money flow indicators on both a daily and weekly basis. We believe with price and volume fading both on a short-and intermediate-term basis, some caution is advised.

One area of the market that caught our eye recently is cyclical stocks. The index we use to monitor the action of cyclical stocks or those that are economically sensitive is the Morgan Stanley Cyclical Index (CYC.X ). This index is comprised of 30 cyclical names from very diverse industries, but all are considered sensitive to the strength or weakness of the economy. The index has been quite a performer since March, 2003, more than doubling to its most recent high in December, 2004.

However, we think there are some worrisome signs concerning the chart. First, the index broke its long-term, bullish trendline drawn off the low in 2003. Second, it appears that the index is tracing out a bearish head-and-shoulders reversal pattern. To complete this formation, the index would have to drop below 700 or another 30 points. Third, there is a major negative divergence with respect to the weekly MACD indicator. And finally, the cyclical index is starting to underperform the S&P 500, breaking a trend of outperformance that has been in place since late 2000. If this index breaks down, we believe it will be giving a warning about the health of the economy.

The bond market took quite a hit last week with the yield on the 10-year Treasury note rising from 4.12% to 4.27%. In the process, the 10-year yield is now back above the 50-day, 100-day and 200-day exponential moving averages. The next piece of support comes from a trendline drawn off the peaks in March and April, which comes in at 4.35%. Chart support, from the peak in yields in August lies at 4.40%, with long-term trendline support up at 4.55%. The next 40-week cycle high for yields is not expected until the end of this year, so this gives plenty of time for yields to march higher.

In addition, bond market sentiment, as measured by MarketVane, has been above 70% bulls for the last four weeks, so there is plenty room for bearish sentiment to rise. This is a condition, in our opinion, that will lead to higher bond yields.

Gold prices broke out of a 9-month consolidation, and soared to their highest level since 1988, finishing the week at $460 per ounce. Since the beginning of 2002, gold prices have benefited from the bear market in the U.S. dollar. However, of late, the U.S. Dollar index has been holding near its recent recovery highs near the 90 level, while gold prices have rallied sharply.

In our view, gold prices may have decoupled from the dollar and are acting more on rising inflationary expectations. Taking the width of the latest consolidation in gold prices and adding this to the breakout point, gives us a new target for gold up near $500. In our view, rising gold prices based on increased inflation expectations is not a good sign for the stock market.

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

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