Stocks: Is the Bear Lurking?

S&P thinks the key to whether the latest weakness turns into a correction is simply the action of the major indexes

From Standard & Poor's Equity Research

From Standard & Poor's Equity Research

Like clockwork, the stock market reversed to the downside last week after many major indexes posted new, recovery highs in early May. Bond yields continued to rise while oil prices rebounded from recent weakness.

The lack of follow through after another move to new highs by the S&P 500, the Dow Jones industrial average, and the Russell 2000, has to be disappointing to the bulls once again, in our view. Since November, 2005, every breakout to new highs has been followed by a pullback. The positive for the market is that the pullbacks have been limited in scope, as many indexes have traced out a series of higher lows. The key right now, in our opinion, is whether the latest weakness turns out to be just another pullback or will we finally see a decent-sized correction, which we believe is long overdue.

We think the key to whether the latest weakness turns into a correction is simply the action of the major indexes. Taking a look at the S&P 500, we can see a very typical pattern since November. The index has pulled back to trendline support, either off of the late December low or the early February low. If that trendline gives way, we may finally see a correction. The trendline off the February lows comes in around 1293. The trendline off the late December low sits at 1280. Another similarity of the recent pullbacks is that the S&P 500 has found support at its 65-day exponential moving average. This average currently comes in at 1297. In addition, every time the 6-day relative strength index (RSI) has gotten oversold, or moved down near the 25 to 30 range, the index has put in a short-term bottom and rebounded. After the close of trading Thursday, May 11, the 6-day RSI was at 36. Another day or two of weakness and the 6-day RSI will be in this oversold range. If these support areas give way, and we fail to get a bounce once we hit short-term oversold levels will be the key to whether the recent weakness turns into a correction, in our view.

If this turns into a correction, there is plenty of support underneath current prices as far as the S&P 500 is concerned. The most recent lows for the S&P 500 are at 1280, 1272, 1254, and 1248. The 80-day moving average lies at 1291, and the 150-day exponential moving average sits at 1274. Strong, intermediate-term chart support comes in at 1246, in our opinion. A 50% retracement of the rally since October also comes in near 1246.

While the S&P 500 is still in a pattern of higher highs and higher lows, and just hit a new recovery high on May 5, the Nasdaq has seen some pronounced weakness of late. The index late posted a recovery high on Apr. 19, and has traced out a series of lower highs and lower lows ever since.

While the recent price dynamics of the S&P 500 has not changed yet, the same cannot be said for the Nasdaq. On May 11, there was some clear technical damage to the Nasdaq, in our view. The index undercut trendline support drawn off the early January low. The Nasdaq sliced right through its 50-day exponential and 80-day exponential moving averages, which many times provide support during intermediate-term advances. This is the first time since early October that the Nasdaq's price has put some distance below its 80-day average. Since early April, the 6-day RSI and the 14-day RSI have put in a series of lower highs and lower lows.

In addition, the 14-day RSI, which had been finding support in the low 40s during the last 4-1/2 months, dropped well below this level late this week, a negative in our opinion. We think key intermediate-term support comes in at 2200 for the Nasdaq. A 50% retracement of the rally since October comes in at 2200 as well as trendline support drawn off the April and October 2005 lows.

If we look at the Nasdaq 100 (NDX), or the largest stocks on the Nasdaq, we see even more technical weakness. The NDX last peaked on Jan. 11 at 1758.24 and is currently more than 100 points below its peak. In addition, the NDX has dropped down to the bottom of the range it has traded in since mid-November. While the S&P 500 and the Dow industrials were hitting recovery highs in early May, the non-confirmation by the NDX was pretty glaring, in our view. It is our opinion that it is much healthier for the market when the majority of indexes are moving in sync, not in opposite directions.

Small-cap stocks have been outperforming the S&P 500 since April, 1999. While we see little evidence that this trend is finished, we do believe the small caps are well overdue for a pullback or correction. Since January, daily momentum statistics have put in a series of lower highs while the Russell 2000 put in a series of higher highs. These negative divergences many times will lead to some type of price weakness. The index has taken out intermediate-term trendline support off the October 2005 lows.

On Friday, May 12, the index undercut its 50-day exponential moving average for the first time since early October. Money flow has deteriorated since late March, setting up negative divergences with respect to accumulation/distribution. A 50% retracement of the rally since October targets the 695 level while intermediate-term chart support lies in the 690 to 710 area.

The bond market sold off again, with the yield on the 10-year finishing the week at 5.19%, another recovery high. Chart support sits in the 5.25% to 5.50% range while long-term trendline support drawn off the major peaks in 1994 and 2000, comes in at 5.25%. While we have been calling for a counter-trend move in rates, it is negative in our view that yields continue to move higher in light of very overbought condition on both a daily and weekly basis. Often, when a market can move higher in the face of overbought extremes, indicates that the market has a lot further to go from a longer term basis.

After hitting an intraday low of $68.25 per barrel on Monday, May 8, crude rebounded to a weekly high of $73.85 on Thursday. Crude fell on Friday and finished at $72. Since peaking at $75.35 on April 21, oil prices have put in a series of lower lows and lower highs. The market had moved to a very overbought condition towards the end of April and momentum indicators have turned lower, a negative in our view.

While we believe there is still a chance for one more move to the upside, we think the chances are high that oil has entered an intermediate-term correction. We see the possibility of a downside break to the $60 to $63 range and target the late June period for a bottom. The 90-day cycle low is due to bottom out towards the latter part of June.