The Bull's Tough Slog Higher

Gains have come despite soaring commodity prices and rising interest rates. Key signals indicate the advance could continue

From Standard & Poor's Equity Research

The equity market continues to grind higher in stair-step fashion, undaunted by soaring commodity prices and rising interest rates. The market reminds us of a heavyweight boxer in the later rounds of a championship fight, taking punch after punch, but never going down. The question now is how much more stamina does the fighter have, and will he get a second wind.

The S&P 500 ran up to trendline resistance, drawn off the January, 2004, March, 2005 and January, 2006 highs, on Thursday, Apr. 20, and Friday, Apr. 21, and backed off both days. This trendline comes in at 1318 and the intraday highs on Thursday and Friday were right at 1318. This piece of resistance has represented a real ceiling for the market of late. Since Mar. 16, the S&P 500 has come close or hit this trendline eleven times. In other words, the index seems to be riding this trendline higher.

While the slope of the line is fairly flat, it is climbing at about 6.3% per year. For illustration purposes, if the S&P 500 continued to ride this trendline until the end of 2006, it would represent a target of 1375 for the end of the year. However, predicting the stock market is never that easy.

It is interesting to note that the S&P 500 has been contained, both in the short term and the intermediate term, by two upwardly trending channels. These bullish channels have overlapping trendlines up at the top but distinct trendlines on the bottom.

The intermediate-term channel started with a price high in December, 2004, and a price low in April, 2005. The bottom of this channel, or important intermediate-term support, comes in at 1225, projecting forward by a couple of months. The shorter-term channel began with the minor bottom and top in January, 2006. Price support from the lower trendline of this channel comes in around 1280, projecting forward about a month.

Momentum indicators, based on the price action of the S&P 500, remain in good shape, in our view. The 14-day relative strength index (RSI) is not yet overbought, which we believe gives the market more breathing room on the upside. The 14-day RSI is also back above 50, another positive in our opinion. The 14-week RSI is not overbought either, and is also above 50, currently in the 68 area.

The daily moving average convergence/divergence (MACD) is in positive configuration, in our view, after pulling back and holding the zero line early this week. The weekly MACD remains in positive territory, well above zero, and is trying to climb back above its signal line.

One very consistent characteristic of the current bull market is the ability of the NYSE advance/decline line to forge higher, making a series of higher highs and higher lows. The most recent recovery high for the A/D line occurred on Apr. 5. Sometimes, the A/D line will top out concurrent with stock prices, and other times, the A/D line peaks out well before stock prices. At major market lows since 1970, the A/D line has tended to bottom out along with prices.

Some interesting long-term observations can be made about this market breadth indicator. Going back to 1970, whenever there was a peak in the A/D line that occurred well before prices, the subsequent decline was fairly dramatic. This happened prior to the latest bear market when the A/D line peaked out in April, 1998. Other, major negative divergences occurred with respect to the A/D line prior to the major corrections or bear markets in 1998, 1990, 1987, 1982, and 1974.

Second, there is a difference in the slope of the A/D line during bull markets. One would expect that during each stage of a bull market, the slope of the A/D line would weaken as the bull market ages. However, that has not been the case going back to 1970. Sometimes the slope weakens as the bull ages and sometimes the slope of the A/D line steepens as the bull market ages.

Third, the NYSE A/D line has remained above its 200-day exponential moving average since early 2003. There was a test of that key average in May 2004 and October 2005, and each time, this long-term support line held.

The A/D line last bottomed out in October, 2000, well before the major indexes bottomed out in 2002 and 2003. Since the last major low in March, 2003, we can break the A/D line up into four advancing stages. The first went from March, 2003, until April, 2004. This was the longest and steepest of the four periods. In each successive run for the A/D line, the slope has gradually lessened, possibly indicating that the bull market is tiring. However, if the A/D line peaks before the end of the current bull market, stocks could have many months ahead before the ultimate peak.

Crude oil prices rose for the sixth straight week, finishing at another all-time high of $75.25/barrel. Prices rose 8.5% on the week, the largest weekly gain since June, 2005. Crude had a significant price breakout last week, taking out key chart resistance in the $69 to $70 zone. Our next target for crude oil prices is in the $76 to $80 range. This is based on Fibonacci analysis, which projects prices based on the width of the prior pullbacks.

If crude prices continue to overheat, it is possible in our view that prices could run up to the top of the long-term channel. This would equate to a move up near $85/barrel.

However, we think this is unlikely during the current advance for a couple of reasons. Daily momentum indicators are very overbought. The 14-day RSI hit 75 on Apr. 19. Over the past two years, the 14-day RSI peaked out between 73 and 79 prior to prices pulling back. The daily MACD is also very overbought.

Also, figures from the Commitments of Traders report, which measures short and long positions in the crude futures market, is giving off warning signals. Large speculators are very bullish on the market while commercial hedgers have grown increasingly bearish on the market. The last time we saw a similar set of numbers was in the middle of August, just a couple weeks before the major Katrina highs.

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