Bulls Aren't In the Clear Yet

The rest of the market is not yet confirming the breakouts by the major blue chip indexes

From Standard & Poor's Equity Research

The S&P 500 and the Dow Jones Industrials broke out last week, completing double bottom reversal formations. Many other indexes continue to base despite the recent rally. Bond yields on the 10-year Treasury fell below 5% while crude oil dropped to $70 per barrel.

After a couple of attempts, the S&P 500 finally closed comfortably above the 1280 level, completing a complex double bottom reversal pattern. We call it a complex pattern because it could also be considered a head-and-shoulders bottom with two heads. The left shoulder was formed at the end of May while the right shoulder was traced out earlier this month. Either way, the formation is considered bullish from a technical perspective, and in our opinion, should allow the index to work higher.

The tricky part right now is trying to project how far the market can run in light of the positive reversal formations that the S&P 500 and the Dow Jones industrial average have put in. Normally, this would be a fairly bullish setup for the stock market. However, we have plenty of concerns going forward. As we said before, the other indexes, including the Nasdaq, Russell 2000, S&P Small Cap 600, S&P Mid Cap 400, and the DJ Transports, to name a few, are still in basing formations and have yet to break out. In other words, the rest of the market is not yet confirming the breakouts by the major blue chip indexes. The indexes that have yet to bust higher have seen some fairly significant technical damage, but for the most part, their longer-term trend remains higher.

Along with this, there has been a relative strength shift to large cap stocks from small and mid cap stocks. We prefer to see smaller growth stocks leading the market because it suggests that investors have a bigger appetite for risk. This rotation to more defensive issues is many times seen toward the end of cyclical bull markets. Often, the best gains in the market are seen when smaller growth stocks are leading the upside.

Maybe even more importantly, both the seasonal and cyclical timeframes are against stocks at this point, in our view. The stock market tends underperform during the May to October period, and the majority of the weakness tends to occur in September and into the middle of October. Many corrective lows as well as bear market bottoms have been put in during October.

In addition, a major 4-year cycle low is due this year, with many of these four-year bottoms occurring in the third quarter. There were either major lows or bear market lows in 2002, 1998, 1994, 1990, 1987, 1982, 1978, 1974, 1970, 1966, and 1962. The 1987 period was a year off but the consistency of this cycle is pretty remarkable. On the bright side, if we do see a major 4-year cycle low this year, they have often been excellent times to back the truck up and load up on stocks.

So with all these negative forces facing the equity markets, we do not see a blow-off to the upside. We think that the S&P 500 could run up to its cyclical bull market high of 1326 before another leg lower takes shape. As it looks now, if the "500" is able to move to its old high, we doubt seriously if the other indexes that are lagging will be able to jump back to their previous highs. This would set up serious nonconfirmations by these indexes and be a pretty good sign, we think, that the bull market was ending. Towards the end of many bull markets, fewer and fewer stocks, as well as indexes, participate on the upside as the action becomes more and more selective.

The Nasdaq has rebounded nicely off its mid-July low down near the 2000 level. To complete the current base or reversal formation, we would like to see the index close above the early July closing high of 2190.43. Even if that were to occur, the Nasdaq faces a heavy dose of overhead resistance, which we believe will limit its upside progress. Immediate resistance comes from a trendline off the 2004 and 2005 lows and sits at 2178. This trendline was support and is now resistance. The 150-day and 200-day exponential moving averages also lie in this area. A 50% retracement of the recent correction may provide resistance at the 2196 level. This also corresponds with a small layer of chart resistance between 2136 and 2234. The 200-day simple average is at 2225 and is also considered a potential piece of resistance.

But the real sticking point for the Nasdaq could come from a fairly thick layer of chart resistance that begins up at 2233. In conjunction with this heavy chart resistance at 2233, a 61.8% retracement of the correction comes in at 2237. Heavy, concentrated areas of support or resistance often take time to penetrate.

Small-cap stocks have been leading the market for quite some time but it appears that trend may be coming to an end. Since April, 1999, the S&P Small Cap 600 has outperformed the S&P 500, and since March, 2000, has bested the Nasdaq. The relative strength (RS) line of the "600" vs. the "500" has broken key long-term trendline support, suggesting that the long-term outperformance by the small caps is ending.

In addition, the RS line has broken below its 80-week exponential moving average for the first time since 2000. The S&P 600 has taken out a key trendline drawn off the lows in 2004 and 2005, another negative in our view. And finally, the monthly moving average convergence/divergence (MACD) has issued a sell signal on the "600" for the first time since mid-2002.

Treasury bond prices continued to rally last week, forcing the yield on the 10-year note down to 4.84%, the lowest since early April. Yields have traced out a series of lower highs and lower lows since peaking at 5.25% on June 28, and we believe are headed for an important test of resistance in the 4.8% zone. Trendline resistance, off the yield lows in 2005 and 2006, comes in near 4.8%. There is also a small piece of chart resistance at 4.8%. A strong break below this level would reverse the uptrend in yields that started in June 2005, in our view.

Weekly momentum turned lower in mid-May and is still heading lower, suggesting that yields have further to fall. Daily momentum is oversold, but weekly momentum is not yet oversold. While lower yields have been supportive of equities over the long-term, one must be cognizant that if yields fall too far, they may be signaling a weakening economy, which has many times not been good for stocks.

Crude oil prices fell to $69.60 per barrel on an intraday basis Friday, Aug. 18, the lowest since June 21, but rebounded to finish the week at $71.14. For the week, crude prices declined 4.3%, the worst weekly performance since mid-May. In the process, prices took out trendline support off the lows in March, June, and July. Since the peak on July 14 at $77, crude has traced out a lower low and a lower high. The next piece of short-term chart support sits at $68, with intermediate-term trendline support near $66. Both daily and weekly momentum indicators are bearish, but not yet oversold.

Major long-term trendline support, off the lows in 2003, 2004, and 2005, sits down near $62. We refer to this line as the bull market trendline, and as long as crude stays above this rising line, we believe the long-term bull market is intact. The monthly MACD is still bullish so we think at this point that crude has entered an intermediate-term decline within a long-term bull market.

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