Time to Bid the Bull Goodbye?

S&P believes there is a good chance for a bear market sometime later this year or early next year

From Standard & Poor's Equity Research

The S&P 500 index and the Dow Jones industrial average tried to break out on Friday, Aug. 4, after an interest-rate friendly July employment report, but after a nasty intraday reversal, the breakout failed. Bonds also benefited from the report while crude oil finished the week near all-time highs.

The S&P 500 once again failed to break above the key 1280 level last week, and therefore the attempt to finally complete a bullish, double bottom reversal formation failed. If the market can regain its footing this week, and take out the 1280 level, the next piece of chart resistance sits in the 1288 to 1291 zone, and this represents the closing and intraday highs from June 2.

Another piece of potential resistance would be a 61.8% retracement of the correction during May and June, and this comes in at 1286. Above 1291, chart resistance sits in the 1300 to 1326 zone. On the downside, trendline support, drawn off the lows since July, comes in at 1275. Multiple moving averages, which could provide support, sit in the 1260 to 1270 zone.

If the S&P 500 can eventually complete this double bottom, we would normally measure the width of the formation and add it to the breakout point to arrive at a potential, intermediate-term target. The width of the pattern was 56.50 points, adding this to the breakout point of 1280.19, gives us a potential measured move to 1336.69. However, in this particular instance, we do not believe this target will be fulfilled.

We will remind you at this time that technical analysis is an art and not a science. First, we believe that the market has entered a wide trading range at best, and the S&P 500 will not break out to new bull market highs. In fact, we still believe there is a good chance we will see a bear market sometime later this year or early next year. This is primarily due to the major market low that occurs almost every four years. Weekly and monthly technical indicators have been deteriorating for quite some time, so the technicals are lining up with the cyclical patterns of the market.

In addition, volume has not been very strong, despite the recent gains in the market. This suggests that institutions are not falling all over each other trying to put money back into stocks. And finally, many of the other major indexes are not acting well, signifying that the stock market is getting much more selective, as well as defensive. This is many times a telltale sign that the bull market is approaching a major peak. In fact, the Nasdaq is still officially in a downtrend as the string of lower highs and lower lows is still intact.

With the stock market getting more defensive since the beginning of May, one of the major beneficiaries of this rotation has been the pharmaceutical stocks. After a brutal bear market from late 2000 until July, 2002, in which the AMEX Pharmaceutical Index (DRG) plunged 46%, the index had a very strong rally, retracing about 50% of the bear market decline by February, 2004. Since that time, the pharmaceutical index has been rangebound. In essence, the group has been stuck in a massive base since 2002.

However, and very slowly, the drug sector, in our view, has been setting up for a major breakout from this base. Since October, 2004, the index has put in a series of higher lows as well as marginal new highs. Last week, prices broke out of this bullish, ascending triangle formation, and are now at their highest level since early 2004. The breakout occurred on very strong volume and money flow is the strongest in about two years.

To complete the massive, multi-year base, the DRG would have to break the July, 2004, high of 353, which is only about 10 points away. On a relative strength basis, the pharmaceutical index has been underperforming the S&P 500 since September, 2001. Just recently, with the move towards defensive stocks, relative strength has improved with the DRG outperforming the "500" since April. The relative strength chart of the DRG vs. the "500" recently broke a downward sloping trendline (resistance) that had been in place since early 2003.

The big beneficiary of the weaker than expected July employment report released Aug. 4 was the bond market. The 10-year Treasury yield fell to 4.90% on Friday, Aug. 4, the lowest since April. In the process, it appears that the 10-year completed a topping formation as yields took out the most recent low from June in the 4.95% area.

On the daily chart, the most recent yield high of 5.25% at the end of June was not confirmed by either the daily or weekly moving average convergence/divergence (MACD). Both of these momentum indicators have rolled over, suggesting that yields are heading lower. There is major trendline resistance as well as minor chart resistance in the 4.8% zone, and we believe yields are headed for a test of this key resistance.

Taking a look at the iShares 20-year Treasury ETF (TLT), we see that a bullish, double bottom was completed on Friday, after a couple months of sideways action. The TLT broke above the interim high of 85.79 on Friday, completing this bullish reversal pattern. Both daily and weekly momentum indicators are bullish, confirming the price breakout.

While the shorter-term pattern is bullish, in our view, major trendline and chart resistance sit up in the 87.50 to 88 zone. Longer term, the TLT is still in a downtrend, so at this point, the rally is just considered a counter trend move within a longer-term downtrend.

Crude oil prices are still in a longer-term uptrend, with higher highs and higher lows still intact. However, there has been a serious breakdown in weekly momentum, and therefore, we believe prices are close to topping out and that an intermediate-term correction is looming. The S&P Energy SPDR (XLE) appears to be tracing out a double top. The most recent weekly candlestick failed right near the most recent high, and traced out a bearish hanging man formation. In addition, there have been multiple negative momentum divergences during much of this year.

Key intermediate-term trendline support for crude oil lies in the $68 per barrel area with long-term trendline support down at $64.

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