Equities Looking Vulnerable

S&P thinks that the underpinnings of the cyclical bull market are starting to unwind

From Standard & Poor's Equity Research

The durability of the stock market rally is now in question, in our view, as stocks took a hit last week on a pickup in volume. Both bond yields and crude oil prices remain in intermediate-term downtrends.

Both Wednesday, Sept. 6, and Thursday Sept. 7, were not pretty days for stock market bulls as both the S&P 500 and the Nasdaq sold off on heavier volume. This was the first sign of distribution by institutions since the middle of August. While the increase in volume during the selloff was not overwhelming, it does elicit some caution, in our view.

We have entered a seasonally challenging time for the stock market, and we think it would be prudent to keep some powder dry. Since 1970, the S&P 500 has fallen 21 out of 36 times during September, or 58% of the time. The range of declines is 0.25% to 11.9%. October has seen its share of stock market weakness as well, especially during the first half of the month. With the 4-year cycle low due in the latter part of 2006, we see a decent probability that the major blue chip indexes will at least retest their summer lows, and believe that some of the other indexes could post new, corrective lows.

We think that the underpinnings of the cyclical bull market are starting to unwind as many of the leading sectors of the stock market and the economy roll over. Housing stocks, which were very strong during much of the bull market, peaked in July, 2005, with many individual issues down 50% or more since then. The Dow Jones Transportation average, another bull market leader, peaked in May, 2006, and fell 17% into the most recent low in the middle of August. The Philadelphia Oil Service Index (OSX) was down as much as 21% in June. The Russell 2000 and the entire small cap universe, a leader since 1999, were down by as much as 14% in the middle of June.

Often, when the leaders fade, the overall market has trouble. This is especially true, in our opinion, when the new leadership that emerges comes from the defensive areas of the market. This has aided the big, blue chip indexes of late, as investors worried about the economy have rotated to areas of the stock market that are less affected by the growth in the economy.

The quandary we face is do we see a major bear market, with all the indexes falling at least 20%, or do we have a market similar to 1994 where the indexes trade in a volatile trading range and just test the lows we posted during June and July. As always, a difficult question to ponder, but if you're on the sidelines, we believe there will be a better entry point sometime later this year.

Besides the damage seen to many leadership areas, there is another piece to this never-ending puzzle. Many times during a bull market, the leaders will correct, quite sharply at times, but will base and bounce back rather quickly. We are not seeing that this time as many of these indexes have yet to retake their 200-day moving averages and remain deep within their respective bases. For instance, the Russell 2000 is back below its 200-day simple moving average and has only retraced about 50% of the decline since May. The DJ Transports are below the 200-day average and are very close to the recent lows. The Nasdaq has only retraced about 50% of the correction and ha been trading below its 200-day average since the middle of May. This is the longest period that the Nasdaq has traded below its 200-day since 2004.

Furthermore, the monthly MACD momentum indicator, which is based on long-term price action, has issued sell signals on all of these indexes for the first time since 1998 for the Transports and 2000 for the Nasdaq and the Russell 2000.

The S&P 500 traced out a bearish candlestick pattern on Friday, Tuesday, and Wednesday, known as an evening star. This is a three bar pattern consisting of a strong up day, a small up day (indecision), followed by a large down day. Many times, this pattern is seen after an intermediate-term advance, and is considered a bearish, reversal pattern. Looking back over the last year, the S&P 500 has traced out similar patterns in November, January, and June, and they were all followed by pullbacks. With the weakness on Wednesday and Thursday, the "500" took out short-term trendline support drawn off the July and August lows. Short-term support is seen in the 1290 zone with more important support in the 1280 zone. Chart support sits at 1280 along with the 65-day exponential and 200-day simple moving averages.

Commodity indexes have been in a strong bull market since the later part of 2001, but there are signs that the RJ/CRB Index is topping out. This index is composed of 19 commodity futures including copper, crude oil, gold, cattle, orange juice, and unleaded gas prices. The index has enjoyed quite a bull market, doubling off the 2001 low to the recent peak in May, 2006. The RJ/CRB index has broken below major trendline support, drawn off the lows put in since 2003.

Secondly, we have gotten a sell signal on the monthly MACD after being on a buy signal since June 2002. The last monthly MACD sell signal was in May, 2001. On Friday, the index closed slightly below its 20-month exponential moving average for the first time since March 2001. On a shorter-term perspective, the index has completed a bearish head-and-shoulders reversal formation that has measuring implications down to the 286 level, which is another 11% below current prices. A 50% retracement of the entire bull market would target the 275 area.

Crude oil prices finished last week at $66.25 per barrel, off 4.3% on the week, and the lowest close since Apr. 4. Prices have now dropped in four of the last five weeks and have declined 14% from the July 14 peak of $77.03. Crude fell below its 200-day exponential average on Wednesday for the first time since mid-February. Prices fell to $66 intraday Friday, testing a very important long-term trendline off the lows since late 2004.

The 14-day RSI has fallen to an oversold level of 30. The 30 area on this indicator has marked some key bottoms for crude oil over the past couple of years. The 14-week RSI is closing in on the most oversold levels seen during the entire bull market, which is near 40. Despite some oversold readings, we have yet to see any positive price divergences that can many times signal that a bottom is near. Therefore, further weakness is possible, in our view. If trendline support at $66 gets taken out, the next piece of long-term support sits down in the low $60s area.

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