Will the Big Caps Back Down?

Many times towards the end of a cyclical bull market, the blue chip indexes will be the last to top out

From Standard & Poor's Equity Research

The blue chip indexes broke out to new recovery highs early last week, with the Dow Jones industrial average closing in on a record high. Both bond yields and crude oil prices reversed to the upside after getting very oversold.

The S&P 500 took out the previous recovery high of 1325.76 on Monday and then proceeded to a close of 1339.15 on Thursday, the highest finish since February 7, 2001. While the strength of the overall market has surprised us of late, we think some of the advance last week had to do with quarter-end window dressing by institutions. We should find out about this premise early in October.

For the near term, the S&P 500 faces moderate trendline resistance, off the recent highs, up at 1345. The index has also run up to the top of a 21-day envelope. This envelope is a 21-day simple moving average, shifted 2% higher and lower than the moving average. Because the envelope is 4% wide, it contains most price action, and does a good job of providing support and resistance for the S&P 500.

During a downtrend, the S&P 500 has a tendency to break below the envelope before an upside reversal takes place. Many times during an early intermediate-term advance, prices tend to break above the envelope in a sign of price strength. During intermediate-term tops, the index will many times fail to reach the top of the envelope before rolling over.

Looking out a bit, key intermediate- to long-term resistance for the S&P 500 comes in around the 1360 level, in our view. This resistance is from the top of the bullish channel that the index has been in since the beginning of 2004. On the downside, there remains a lot of support not too far from current prices, in our view. Trendline support off the recent lows sits at 1320; the 20-day simple average is at 1316, with layers of chart support at 1310, 1300, 1290, and 1280. Other potential supports come from the 50-day exponential average at 1301, with longer-term moving averages down in the 1275 to 1282 zone.

While the DJIA and the S&P 500 have risen to new recovery highs, many of the more volatile indexes are still playing catch-up. Many times towards the end of a cyclical bull market, the blue chip indexes will be the last to top out. Investors have a tendency, we think, to rotate towards large cap stocks as a way of getting more defensive, and away from more volatile, growth oriented stocks. If these other indexes can rebound to new recovery or all-time highs, this will all be a moot point.

The Nasdaq is still about 4% below its Apr. 19 high of 2370.88, the S&P Small Cap 600 remains over 7% below its May 8 high of 404.89, the S&P Mid Cap 400 is also more than 7% from its May 8 high of 817.95, while the Dow Jones transportation average is over 10% under their May 9 high of 4998.95. We certainly would not expect all the indexes to break out on the same day, and it is more common for the more volatile indexes to hit new highs, following a good-sized correction, after the blue chip indexes because they often decline more during corrections. We are however concerned because some of the other indexes still have a lot of ground to make up and have not really broken out of their basing formations.

After the pullback into the April 2005 lows, both the S&P 500 and the Nasdaq recovered to hit new recovery highs on Nov. 18, while the S&P 600 moved to a record high on July 5, well before the "500" and the Nasdaq. The DJ Transports hit an all-time high on Nov. 2, also before the blue chips.

Looking back at the pullback/recovery in 2004, the S&P 500 was able to hit a recovery high on November 4, while the Nasdaq lagged and did not make a new high until December 1. The pullback was larger than the one towards the end of 2005, and therefore it took longer for the Nasdaq to recover. Both indexes bottomed in August of that year, well after the Transports and Small Cap indexes. The DJ Transports hit a recovery high on June 23, and the S&P Small Cap index posted an all-time high on October 1. Obviously, the leadership and complexion of the market has changed with the larger stocks hitting new recovery highs and many other issues and indexes lagging badly.

Along with these lagging indexes, it is evident to us from the new 52-week high statistics that fewer and fewer stocks on the NYSE are doing as well as the blue chip indexes. For the current bull market, the peak in NYSE new highs occurred on December 1, 2003, when over 18% of issues traded on the NYSE were at 52-week highs. Since that peak, we have witnessed a lower percentage of new highs even though the NYSE and the S&P 500 have continued to post recovery highs. In July, 2005, over 14% of issues traded hit new highs. This declined to about 13% in January, 2006, and to 11.5% in May, 2006. The most recent peak at the end of August saw only 6% of issues trade at 52-week highs. We believe this shows that the market is getting more selective.

Bond yields reversed to the upside last week, with 10-year Treasury yields finishing at 4.63%. The 10-year yield closed at 4.55% on Monday, its lowest since Feb. 28. This put the Treasury bond squarely in an area of chart resistance between 4.4% and 4.6%. It also put the 10-year yield 70 basis points below the federal funds rate, the most inverted the yield curve has become since early 2001. With the trough in yields on Monday, Sep. 25, the market had retraced 50% of the yield spike from June, 2005, until June, 2006. On Monday, the market had also moved to an extreme oversold level with the 6-day RSI below 12 and the 14-day RSI just below 22. This is the most oversold the market has been since May, 2003.

We think yields put in at least a short-term low last week, and see yields climbing back towards 4.8%. To reverse the current intermediate-term trend in rates back to the upside, we would expect to see a period of a couple months in which yields base.

Crude oil prices also reversed last week, after falling below $60 per barrel on an intraday basis on Monday, Sept. 25. This was the first time crude was below $60 since Mar. 21. Prices had fallen to long-term trendline support during the week, and had also gotten very oversold on a daily basis. We think crude oil bottomed out last week and believe prices could retrace about 50% of the latest decline, taking them back to $68. There is also chart resistance in that area. We would then expect to see some more testing of the recent lows before calling an end to the current intermediate-term correction.

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