Encouraging Signs for Stocks

The S&P 500 is tracing out a possible "double bottom" that could lead to additional upside

From Standard & Poor's Equity Research

The major indexes continue to work on potential, bullish reversal patterns last week, in what has become a real tug of war between the bulls and the bears. Crude oil dropped sharply on Friday, July 28, heading back below $75 per barrel, while the yield on the 10-year Treasury note retreated back to 5%.

The S&P 500 is tracing out a possible double bottom that if completed, could lead to additional upside, in our view. The first closing low occurred on June 13 at 1223.69 with the second low posted on July 17 at 1234.49. The successful test in mid-July occurred on lower volume, which we think is bullish. Lighter volume tests of support are one of the main characteristics of a successful market bottom. The interim rally, or the rally in between the lows, took the S&P 500 to a closing high of 1280.19 on July 3.

To complete the double bottom pattern, this interim high must be taken out on a closing basis. We believe it would be more bullish for the market to break strongly above the 1280 level on above average trading volume.

For the last couple of days, the S&P 500 has run into trendline resistance, drawn off the peaks in early June and early July. This trendline sits at 1272.50 and was busted during Friday's rally, a positive in our view. Additional resistance comes from the 80-day simple moving average at 1276. Chart resistance above the 1280 level begins at 1285 and runs all the way up to the recovery highs at 1326. A 61.8% retracement of the May/June correction targets the 1286 level. On the downside, a multitude of moving averages come in around the 1260 area. Chart support sits in the 1220 to 1260 zone.

The daily MACD (moving average convergence/divergence) is positive while the 14-day relative strength index (RSI) has traced out a series of higher lows and higher highs over the last couple of months. Additionally, the 14-day RSI is back above 50, a positive in our view. The weekly stochastic oscillator has turned bullish after getting oversold, while the weekly MACD appears to be bottoming.

The Nasdaq's chart formation, relative to many of the other major indexes, is weaker, in our view. The index is still in a downtrend having traced out a series of lower lows and lower highs. While the S&P 500 was successfully testing its June lows, the Nasdaq undercut its June lows by 2.5%. However, the Nasdaq will often put in a lower low during intermediate-term bottoms. The positive to all this was that trading volume was a bit lighter on the low in July vs. the low in June.

In addition, with the lower low, momentum indicators based on the Nasdaq traced out positive divergences during the last couple of months, a potential bullish sign in our opinion. The 14-day RSI, after bottoming in May, has put in two consecutive higher lows while the Nasdaq was tracing out two straight lower lows. The daily MACD put in a higher low in July, indicating that downside momentum was waning. There are a couple of key pieces of resistance that we believe must be cleared before the Nasdaq can see any kind of upside momentum. Trendline resistance, off the recent highs, lies at 2155. Chart resistance sits at 2190 from the peak in early July and a plethora of key moving averages lie in the 2128 to 2225 range.

The Dow Jones Transportation index, which has led the bull market since October 2002 and actually went to a new all-time high, appears to have topped out from at least an intermediate-term perspective. Whether this is just a major correction for the Transports or the beginning of a bear market is too early to tell. However, from a longer-term standpoint, it bears watching in our view, because when the leaders start to fail, we think that it is not a good sign for the overall market.

From October 2005 to May 2006, the DJ Transports ran up 39%. The index then traced out a double top up around the 5000 level. The interim low of 4441 in mid-June was taken out along with the 200-day exponential moving average. Weekly momentum is bearish, however monthly momentum, which has been bullish since mid-2003, is still bullish. Also, long-term trendline support off the lows 2004 has not yet been busted. This trendline sits down near 4050. We believe the breakdown in the Transports is another indication of the massive rotation that is going on from economically sensitive issues to those stocks less affected by the economy.

Market sentiment, despite the stabilization in the major indexes, remains tilted heavily towards the bearish side, a potential bullish factor moving forward, in our view. The American Association of Individual Investor's poll is a great example of this with only 23.9% of its participants bullish and a whopping 57.8% bearish. This is the highest percentage of bears since February, 2003, just before the major low in March of that year. The almost 34 percentage point difference in favor of the bears is also the most extreme bearish reading since February, 2003.

The 30-day exponential average of the CBOE put/call ratio has been trading up near 1.00 or above since the middle of May and has basically been in all-time high territory for the entire time. While very high put/call ratios have often been signs of panic and bullish for the stock market, we don't normally move into a sustainable uptrend until the trend changes in the put/call ratio. It looks like that is finally starting to happen. The recent peak in the 30-day p/c ratio was 1.09 on June 14. The subsequent peak on July 18 was 1.05, setting up the possibility that the trend in p/c ratios is starting to head lower, a potentially bullish factor in our opinion.

Crude oil took a hit on Friday, ending the week about even. While crude oil remains in an intermediate-term and long-term uptrend, momentum is weakening. The daily MACD failed to confirm the latest move to all-time high by crude oil. Weekly MACD peaked out in September, 2005, and has not confirmed the latest high in oil. We can also see this with the daily and weekly RSI readings. So the warnings are there even though the intermediate and long term patterns of higher highs and higher lows is still intact.

In the near-term, important trendline support, off the lows in March and June, sits at $73/barrel. Chart support lies in the $68 to $74 range. Chart resistance is up in the $75 to $78 range, and it is minimal as there has not been a lot of trading in that area. So even though the trend is still higher, there is the possibility from a momentum perspective that crude oil could see a lengthy consolidation or possibly an intermediate-term correction over the next three to six months.

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