Trouble Down the Road

S&P sees further losses for stocks over the next month or two, though a counter-trend rally is possible over the near term

By Mark Arbeter

The stock market got through September without much trouble, but so far, October has been a different story. The major indexes got slammed by a wave of selling, and in the process, took out some key technical support levels, in our view. While we see further losses for stocks over the next month or two, we believe it is possible to get a counter-trend rally over the near term.

The S&P 500 broke some important pieces of technical support last week, and unfortunately, confirmed the bearish, double top formation. On Wednesday, Oct. 5, the index closed at 1196.39, breaking the most recent closing low of 1205 from late August, and the index also fell below August's intraday low of 1201. Additionally, the 1.5% decline on Oct. 5 was the worst one day performance for the S&P 500 since Apr. 15, when the "500" dropped 1.7%.

Trading volume was very heavy last week, adding to our concerns about the equity markets. Volume on Tuesday was 1.7 billion shares, and rose to 1.9 billion on Wednesday and 2.1 billion on Thursday. This intense selling was easily higher than the 50-day average of 1.5 billion shares. The three-day average of volume (Oct. 4, 5, 6) was the highest since April. In our opinion, institutions hit the sell button hard last week, and we think this move out of the equity markets is a warning sign for investors.

Over the near term, we believe the stock market could bounce, but think any rally will be counter-trend in nature, and eventually fail. The S&P 500 fell to some decent technical supports on Thursday, and in combination with a severe short-term oversold condition, sets the market up for a potential bounce. The most important piece of support that the S&P 500 bounced off of on Thursday is a trendline drawn off the August, 2004, and April, 2005, lows.

In addition, a short-term trendline drawn off the recent lows also acted as support on Thursday, in our view. Minor chart support between 1180 and 1190, from the lows in late June/early July, may also have been a contributing factor to the stabilization on Thursday and Friday. Overhead, there is chart resistance in the 1200 to 1210 zone. The index has traced out a series of lower highs and lows so a rally up to the top of the downward sloping channel could lift the index up to the 1224 area.

The recent swift decline has dropped the market into a relatively extreme oversold condition and this is another reason why we believe a bounce is possible. The 6-day relative strength index (RSI) fell to 19 on Thursday, the lowest since April, while the 14-day RSI fell to 33, also the lowest since April. The 4-day price rate-of-change (ROC) for the S&P 500 was -3% as of Thursday's close, the weakest 4-day performance since April. Looking at an internal measure, the 10-day NYSE down/up volume ratio on Thursday hit its highest level since April. Over the last couple of years, these oversold conditions have preceded some pretty good rallies, including the one off the April lows.

One telltale sign of a bull market is its ability to rally strongly after getting oversold. On the other side of the coin, bear market rallies from oversold conditions can be sharp but do not last very long. A failure to sustain price strength after getting oversold is very negative in our view, so we believe the next month or so will be very telling for the market.

In the intermediate term, the technical damage last week was intense enough to suggest that further losses are ahead. Adding the width of the double top, and then subtracting this from the breakdown point gives us an initial downside target of 1155. In addition, there is pretty good chart support in that zone because that's where the S&P 500 bottomed in April. This area is also important from a support standpoint because a 50% retracement of the rally off the August, 2004, lows comes in at 1154. Besides breaking chart support in the 1200 to 1210 area, the S&P 500 fell below some key moving averages this week, including the 50-day, 150-day and 200-day exponential moving averages. The index also took out trendline support drawn off the June and August lows.

The Nasdaq busted through key chart support at 2100, and continued its pattern of lower highs and lower lows. The index also broke below its 50-day and 80-day exponential moving averages. The Nasdaq also took out its longer-term, 150-day exponential moving average for the first time since mid-March and is almost 6% off its August 2 closing high of 2218.15. Like the S&P 500, the index found support Thursday and bounced higher. Trendline support, off the recent lows, comes in at 2079, with the 200-day exponential average at 2083.11. The Nasdaq closed at 2084.08 on Thursday, respecting this long-term average for now. Other support includes a layer of chart congestion from earlier in the year between 2050 and 2100. More significant chart support lies down in the 1900 to 2000 area and a 50% retracement of the rally since August 2004 targets the 1985 zone.

Sentiment remains mixed toward stocks despite the recent price weakness. CBOE put/call ratios are very high, and eventually that could be a positive in our view. However, equity-only put/call ratios remain very low, indicating complacency among some option investors. Market sentiment on some of the investor polls has moved away from extreme bullish readings, but are not yet at levels that have preceded many market lows. For instance, the difference between bullish and bearish investors on the Investor's Intelligence poll is showing 21.7% more bulls. At the last low in April, there were only 13.1% more bulls, and at the major low last August, there were only 9.4% more bulls.

Crude oil prices fell sharply last week, finishing at $61.84 per barrel, off $4.40 or 6.6%. Crude oil has put in a head-and-shoulders top as well as a descending triangle. Both these formations imply a measured move down to the $55 area, in our view. Both daily and weekly momentum indicators are negative, which we think should keep pressure on prices. There is a zone of support between $56 and $61, which could provide some support. In addition, a 50% retracement of the rally since May targets the $58 level while a 61.8% retracement of the rally targets $55.50. The last major correction for crude oil (during April and May) retraced 61.8% of the prior rally. The 200-day exponential moving average lies at $56.

Treasury bond yields moved slightly higher last week, with the 10-year hitting an intraday high of 4.44% on Friday, before pulling back to finish at 4.36%. Friday's intraday high was the highest yield for the 10-year since back in April. The 10-year yield has moved into an important area of chart support in the 4.4% zone, which was the high from August. More important perhaps is the fact that yields broke above trendline support, drawn off the March and August highs. This suggests to us that yields are headed higher over the near-to intermediate-term. The next zone of important chart support is between 4.5% and 4.7%. There is also long-term trendline support, off the yield highs in May, 2004, and March, 2005, up at 4.55%.

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

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