A Resilient Stock Market

So far, the global rise in commodity prices and bond yields has not weighed on equities

From Standard & Poor's Equity Research

Last week was quite an amazing one for the financial markets. The Nasdaq moved to a new recovery high, many commodities rose to multi-decade highs, while bond yields increased to their highest levels since the middle of 2004. In our view, many would wonder if the global rise in commodity prices and bond yields would start to weigh on equities. So far, that has not been the case.

The Nasdaq eclipsed its previous recovery high of 2331.36 from back on Jan. 11, closing at 2337.78 on Thursday, Mar. 30. Volume was 2.45 billion shares on Thursday, well above average and the third highest this year. Because the breakout was only mild from a price perspective, we would like to see the index extend its recent gains by at least 1% beyond the breakout point before getting too excited. The Nasdaq has been lagging both the Dow Jones industrial average and the S&P 500 since the latter part of January but with this week's performance, the index is quickly catching up. Another potential problem was that the burst occurred at the end of the quarter, which brings up the possibility that institutions needed to raise their allocations to stocks before quarter-end. Therefore, we would like to see this strength extended into the second quarter before jumping on board.

If the Nasdaq can extend its gains, the index could run up to the top of a channel that has been in place since April, 2005. This would target the 2400 area. In addition, taking the width of the latest consolidation, multiplying this by 1.618, and then added this to the breakout point gives us a Fibonacci target that is also near 2400. Chart support is fairly thick in between 2200 and 2333. Both the 50-day simple and 50-day exponential moving averages lie at 2286, and could provide support during a pullback. Trendline support, off the lows in January and March, comes in at 2263.

An interesting indicator we have been watching closely of late, and one that ties in with the strength in the Nasdaq this week and the big increase in volume is the ratio of Nasdaq weekly volume to NYSE weekly volume. Often, when Nasdaq volume spikes in relation to NYSE volume, a pullback or correction is not far behind. The difficult part about using an indicator like this is that it is hard to define what an extreme relationship is between volume on the Nasdaq and the NYSE.

We use history as a guide but will give an interesting example of different market environments. During the bull market of the late 1990s and early 2000, and even after the Nasdaq's peak in March, 2000, Nasdaq volume rose to 2 times that of NYSE volume. During the bottoming process in 2002 and 2003, Nasdaq volume fell to below 90% of NYSE volume.

Looking at this indicator with a 3-week moving average since 2003, we see some stability and also some predictability. When the 3-day moving average falls below 110%, as it did in October, 2004, April, 2005, and October, 2005, the market was at or near an intermediate-term bottom. When the 3-day average rises above 140% like it did in January, 2004, and January, 2005, the market was at or near an intermediate-term top. We are currently on a buy signal that was generated in October, 2005, when the indicator fell to 97%. The current 3-day average has risen to 138%, very close to levels that have preceded pullbacks or corrections.

Some commodity prices broke out this week and the bull market in the Commodities Research Bureau (Reuters Jeffries CRB) index that began in October, 2001, remains in a strong uptrend. Crude oil prices broke out of a base that started in the middle of February by taking out chart resistance in the $64 area. Crude rose as high as $67.30 on Thursday, the highest level since Feb. 1. With this breakout, we believe crude oil completed a base and is now in an intermediate-term uptrend. Chart resistance comes in between $69 and $70 from the highs in August, 2005, and January, 2006. Trendline resistance, off these peaks, sits at $68.50.

Both the daily and the weekly MACD are in bullish configurations, suggesting additional gains are possible, in our view. If crude can bust above the $70 level, we think prices could then run up to the top of the current bullish channel near the $80 level. Taking the width of the consolidation since August 2005, multiplying this by 1.618, and adding the product to the breakout point, gives us a Fibonacci target that is also near $80.

Gold prices broke out of a two-month consolidation and closed at $586.70 on Thursday, the highest level since January, 1981. Gold prices are up a whopping 40% since July, 2005, and 19% since December. Long-term trendline resistance, drawn off the major highs in 2003 and 2004, comes in at $610. What impresses us the most about the gold chart, is that despite being very overbought on weekly basis in early February, the metal only retraced about 23.6% of the major advance that started in July, 2005. Silver prices also rose this week and have surged about 70% since the end of August, 2005. Silver has almost tripled since its bottom in November, 2001, and is now trading at its highest level since 1983.

Treasury bond yields broke out once again, and the 10-year finished the week at 4.85%, slightly below Thursday's intraday peak of 4.88%. This is the highest close and intraday peak for the 10-year Treasury since May and June, 2004. On May 14, 2005, the intraday high reached 4.9%, and on June 14, yields closed at 4.87%. If the 10-year clears these levels, yields will be at their highest level since June 2002.

While we have been bearish on bonds for some time, it is interesting to note that the structure of the latest advance in yields is much different from the advances in 2003, 2004, and early 2005. Those moves to the upside were virtually straight up, and therefore, unsustainable. The current move in yields since the June 2005 low has taken on a stair step pattern, with a series of higher highs and higher lows. This type of advance is much more durable, in our view, and may be a sign that yields have further to run, and will finally break out of their long-term base, and reverse the very long-term bull market in bonds.

One look at the weekly chart of the iShares 20-year Treasury (TLT) suggests to us that a major break to the upside in yields could occur. The TLT has completed a massive head-and-shoulders reversal pattern, taking out the neckline this week, which was at 88. The width of the head-and-shoulders pattern was 10 points, so a measurable downside target would be 78. There is long-term chart support at 81. A move of this magnitude, either to 81 or 78, would be very negative for stocks in our view, and push the 10-year well above 5%.

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