Stocks: More Pain Ahead?

Key measures indicate heavy selling by institutions -- never a good sign, in S&P's view

From Standard & Poor's Equity Research

The stock market correction is finally here. The good news: The quicker the drop, the quicker the potential bottom. The bad news: We think this is a warning of something much worse later this year.

Last week, the S&P 500 fell 2.1% and is off a whopping 4.6% since May 5. The 9-day rate-of-change (ROC) as of the close on Thursday was -4.8%, the worst nine-day performance for the S&P 500 since February 2003. The Nasdaq, which dropped eight straight days following Thursday's loss, fell 2.8% this week and has plunged 7% since May 8 and 8% from its recovery high on Apr. 19. The 8-day ROC of -7% for the Nasdaq is the worst performance since August 2004.

Not to be left out, the Russell 2000 fell 3.5% this week and has fallen 8.4% from its May 5 all-time high. The nine-day drop for the small cap index is the worst since May 2004.

The S&P 500 has sliced through quite a number of key short-term and intermediate-term technical supports like a hot knife through butter. The index has dropped right through its 50-day, 65-day and 80-day exponential moving averages. It has also fallen below its 150-day exponential moving average as well as its 200-day exponential average for the first time since Oct. 5. The 200-day simple moving average sits at 1257.62 and was tested on Friday, May 19.

The "500" has also taken out trendline support off the recent lows this year as well as trendline support off the October lows. At this point, we are targeting the 1246 area as a possible bottom for this correction. There is a lot of chart support in this zone from the bottom at the end of 2005. This area also represented a peak for the S&P 500 back in August and September of last year. In addition, a 50% retracement of the advance from October to May targets the 1247.45 level.

We think any intermediate-term bottom will take a week or two to form and will be characterized by a series of successful tests of the final low.

Longer-term trendline support, drawn off the August, 2004, and October, 2005, lows, is at 1240. The 10-month exponential moving average, which has provided support during 2004 and 2005, lies at 1259. The last time this longer-term average was taken out was way back in November, 2000, and the S&P 500 has been trading above this average since April, 2003.

The 20-month exponential moving average is at 1222. The 10-month exponential moving average still sits above the 20-month average, giving us one of many confirmations that the "500" is still in a long-term bull market. However, if we do get a cross of these long-term moving averages, it would be one sign to us that the market has transitioned into a bear market.

While there has been little to suggest that the market has hit at least a short-term bottom from the recent chart action and volume, there are numerous technical indicators that are suggesting we may be getting close to at least a tradable bottom. To begin with, the ROC data that we mentioned above suggests that the market is extremely oversold on a short-term basis.

In addition, there are numerous internal measures that are flashing oversold extremes. The 5-day summation of NYSE TRIN hit 7.33 on Thursday, the highest and most oversold that this measure has posted since January 5, 2005. The TRIN or Arms Index shows the relationship between the number of stocks that increase or decrease in price and the volume associated with stocks that increase or decrease. Basically it shows whether volume is flowing into advancing stocks or flowing into declining stocks. The 5-day summation of Nasdaq TRIN hit 8.00 on May 17, the highest since early 2006 while the 10-day summation of Nasdaq TRIN rose to 14.39 on Thursday, the most oversold since September 2004.

These high TRIN readings are a clear indication of heavy distribution by institutions, never a good sign from our view. Another way to measure distribution is to look at up/down volume ratios on the Nasdaq. The 6-day summation of Nasdaq up/down volume fell to 0.32 on May 17, matching the lowest level since September 19, 2002. The prior low of 0.31 occurred on April 4, 2001. This is an extremely oversold reading as we have only seen this measure fall to 0.32 or below 6 times since the beginning of 2000.

The 10-day summation of Nasdaq up/down volume fell to 0.49 on May 18, the lowest reading since July 16, 2004. Often, extremely low levels of up/down volume ratios are associated with an intermediate-term low. Unfortunately, some of these intermediate-term lows occurred during bear markets and just represented counter trend rallies within a longer-term, declining market.

We have seen a fairly dramatic shift in some sentiment indicators since early May as sentiment has quickly shifted from complacency to fear. The 10-day exponential moving average of the total CBOE put/call ratio has shot up from 0.83 on May 5 to 1.12 on May 12. This is the highest reading for the 10-day P/C ratio since December 1994. The 5-day simple moving average CBOE put/call ratio has jumped from 0.81 on May 5 to 1.27 on May 18. This is actually slightly higher than the extremely high readings from back in December, 1994. The 30-day CBOE P/C has risen to 0.97, the highest since November 1, 2005.

Along with the spike in put/call ratios, there has been a spike in the volatility indexes. The VIX or volatility index of the S&P 500, which measures option premiums, has exploded from 11.6 on May 5 to an intraday high of 18.01 on May 19. This is the highest reading for the VIX since April, 2005. Over the past couple of years, dramatic spikes in the volatility indexes have been associated with intermediate-term bottoms.

Crude oil prices fell once again, finishing the week at $68.45, down 5% on the week. Crude has now dropped three out of the last four weeks. Prices have traced out a series of lower highs and lower lows since peaking at $75.17 on April 21. Daily momentum indicators continue to drop, but are not yet oversold. Initial chart support is seen at $68, from the highs in late January.

In the Commitment of Traders report, commercial hedgers (smart money) are very bearish on crude, while large speculators (dumb money) are extremely bullish on oil. In our view, this combination is bearish for prices. We still believe crude will bottom towards the latter part of June down in the $60 to $63 area.

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