Stocks: Not Out of the Woods Yet

Continued volatility could have bearish consequences for the market, says S&P

From Standard & Poor's Equity Research

Volatility, unfortunately, is one of the major themes of late when looking at the stock market, and if it continues, we believe it will have bearish consequences for the equity markets.

The stock market bounced sharply on Thursday, June 15, reversing what had been another ugly week. The S&P 500 rose 2.1%, its best percentage gain since October 1, 2003. The Nasdaq jumped 2.8%, the largest rise since March 25, 2004. Unfortunately, most of the biggest moves of late have been to the downside, and many times, the largest one-day jumps occur during bear markets.

The instability of the stock market is fairly clear when viewing a short-term chart of any of the major stock indexes. For example, the S&P 500, over a 5-week period starting on May 5, fell 5.5%, the largest decline since February 2003. Looking at volatility on a daily basis, we found that the S&P 500 (starting on May 5) has risen or declined by at least 1% in 11 out of 29 days. This matches a period during March/April, 2004, when the stock market was in a corrective move following the big advance off the March, 2003, lows.

So, is the market out of the woods yet or will there be more damage? In the short term, it is too early to tell from our perspective. There are many technical signs that a short-term bottom is near, but in this environment, it is safer to wait for some strong confirmation. The last week or so of the correction saw some of the strongest leaders of the bull market get taken down with the rest of the market. Many times, a market does not bottom until the stocks that have held up the best finally get hit.

On another positive note, the S&P 500 found support and reversed on Wednesday, June 14, at the 20-month exponential moving average. We believe holding above this key long-term average is critically important for the health of the stock market, as this average has done a good job providing support during bull markets from an historical perspective. A break below this average in conjunction with a crossover of the 10-month exponential moving average below the 20-month average would be a major signal, from our vantage point, that the stock market has transitioned from bull market to bear market.

It does seem that the stock market at least put in a short-term low last week. Upside potential for the S&P 500, in our opinion, is in the 1260 to 1280 zone because there is a fair amount resistance in that range. Chart resistance, from the small consolidation in late May, sits between 1260 and 1290. A 50% retracement of the correction so far targets the 1273 level. Trendline resistance, off the most recent peaks, is at 1270. The 50-day, 150-day, and 200-day exponential moving averages all lie between 1262 and 1277. With this amount of concentrated resistance overhead, it is unlikely that the "500" can punch right through all of this on a first attempt, in our opinion.

If the index can extend into this range in the near-term and then rolls over and heads back down towards the recent lows near 1220, we would like to see the retest accompanied by lighter volume. It would also be a positive if some positive momentum divergences were to take place on the daily charts. In addition, an improvement in internal measurements during a test would also be a plus. In would then be important, in our view, for a strong rally on higher than average volume to develop, propelling the S&P 500 through the interim high that develops. If all this occurs, then technically we can suggest that the market is out of the woods on a short- to intermediate-term and that a double bottom reversal formation was confirmed. Until then, we believe caution is warranted.

Internally, we think the market is washed out. The number of new NYSE 52-week lows plus the number of Nasdaq new lows hit 515 on June 13, reaching an oversold or washout level. This number of lows comes very close to the levels seen in October, 2005, which represented the last intermediate-term bottom for the market. Over the past couple of years, a market bottom was near when the summation of new lows rose to 416 or above. However, this assumes that we are still in a bull market. During bear markets, the number of new lows rose to much higher levels at intermediate-term bottoms. This is one of the many reasons why it is always safe to wait for confirmation that a low has been traced. Oversold readings with respect to price and internal data have worked well during bull markets but can be a trap during bear markets.

The NYSE advance/decline line has been in an uptrend since March, 2003, but it is starting to give off long-term warning signals, in our view. While the A/D line has traced out a series of higher highs and higher lows over the last three years, the slope of the rise has clearly deteriorated over the last year. Just lately, the A/D line has broken through its 50-day and 150-day exponential moving averages for the first time since last October. The A/D line is currently testing its 200-day average for the first time in this bull market. A break below the 200-day average would be another nail in the coffin for the bull market. In addition, the 10-day exponential moving average of the A/D line has traced out a series of lower highs since June 2003, illustrating that the advance has been getting more selective as the bull ages.

Investor's Intelligence poll of newsletter writers is rapidly showing a pickup in bearish sentiment, and from a contrarian view, a potential positive. The latest statistics are somewhat amazing in light of the relatively small correction thus far. Bullish sentiment has fallen to 38.7%, the lowest reading since the bear market low in October, 2002. Bearish sentiment has jumped to 34.4%, the highest level since the April, 2003, right after the last bottom during the bear market. This is the most even split between bullish and bearish sentiment since March, 2003.

Unfortunately, like the internal data mentioned above, sentiment could continue to move towards the bearish camp if prices continue lower. For instance, at the bear market low in October, 2002, bearish sentiment exceeded bullish sentiment by 15 percentage points. That was actually the last time that bearish sentiment was greater than bullish sentiment.

While we do expect some short-term relief, we think it would be best to lighten up on any rally.

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