Stocks: Sell-Off or Surge?

A look at trading during similar market action in past years suggests indexes could be in for a major move

The blue chip indexes paused last week while the Nasdaq played some catch-up, finally breaking out to a new recovery high. Small- and mid-cap stocks made new all-time highs. Crude oil prices busted above key resistance at $60 per barrel while 10-year Treasury yields remained around the 4.7% area.

The behavior of the blue chip indexes since November has been eerily similar. The S&P 500 index and the Dow Jones industrial average have been able to break out to minor new highs, and then see very minor pullbacks back to trendline support as well as the 30-day exponential moving average. This is then followed by minor new highs as the process continues.

On the S&P 500, the last two moves have been almost identical, as it seems the market is trying to lull us to sleep. The index will advance for three straight days, putting in a minor new high. This has been followed by very quiet sideways action for 5 straight days. Then, the "500" will pull back for two straight days, right back to support. If this short-term pattern holds, the current pullback should hold support in the 1440 area where the 30-day average and trendline support sit.

With price volatility very low, volatility indexes at or near record lows; there has been a lot of talk about a major move to the downside. We have been looking for a small correction early this year, and unfortunately, are still looking for it. So, as we always do when our trusty indicators that have worked so well in the past are rolling snake eyes, we dig a little deeper and try to come up with an alternative view.

Looking back at recent history, we looked for a similar pattern by the S&P 500 of a strong, narrow advance, followed by an advance that was not as steep. We also looked for periods of market history when the uptrend or price channel was very tight, with little volatility from highs to lows. We also looked for instances where the index is very extended or overbought on a weekly basis, and a market that had seen overbought levels on a daily basis in the recent past.

Interestingly, we came up with two periods that occurred right after the 4-year cycle low. The first was back in 1995, which was right after a four-year low occurred that was not a bear market. That matches the current period pretty well, because 2007 is the first year after a four-year cycle low that did not have a bear market. During 1995, the advance was extremely tight as the market climbed for the entire year. There was a mini-shakeout in December, 2005, that took the S&P 500 down 3.7% in five days. The index then stabilized and preceded to have a mini, upside blow-off, exploding 10.5% in just 23 trade days. This was followed by a couple months of sideways trading, and then another upside breakout that failed. The S&P 500 then finally saw a pullback of some substance, falling 7.4% in about a month and a half.

The other time that most of these characteristics were evident was back in 2003 and early 2004. While the four-year cycle low was in 2002, the final low for the bear market came in the spring of 2003. From there, the market rose rather sharply until the middle of the year, when the "500's" advance flattened out a bit. There was a mini-shakeout in September that knocked the S&P 500 for a 4.2% loss in eight trade days. Once again, the market stabilized and then had another mini blow-off, surging 12% in 55 trade days. The index then preceded to have a choppy pullback of 8.9% into the August, 2004 lows.

While we still would prefer to have a small correction now, as we believe it would be easier to call the market over the rest of the year, a mini, upside explosion of 10% over the next month or two would take the S&P 500 up near the 1600 level, which just happens to be our target for the end of the year.

The Nikkei 225 broke out to new recovery highs last week and the index is at its highest level since May, 2000. The Nikkei has risen 139% since its bear market low in April, 2003. Since that bottom, the index has been in a volatile, bullish channel. If the Japanese market can run up to the top of this channel, it would represent a move to the 21,000 zone. This zone is important because it represents the last major chart high from back in April, 2000.

The latest break higher could be significant, because it broke a downward sloping trendline that has been in place since 1996. Since the latter part of November, the Nikkei has outperformed the S&P 500. Prior to that, the Japanese market had underperformed the "500" since April 2006. The Nikkei severely underperformed the S&P 500 for much of the 1990's but, over the last seven years, has been tracing out what appears to be a very constructive base on the relative strength chart. We will warn you that the Nikkei is overbought on a daily and weekly basis, but so is just about every other major index.

Crude oil prices finally popped above the $60 per barrel level last week, and held, and we think there could be some more upside. With this week's strength, prices have broken above intermediate-term trendline resistance formed off the peak last summer. Crude oil has also retraced more than 38.2% of the bear market, so the next Fibonacci resistance is at the 50% level or about $64. There is some chart resistance that runs from $60 up to $64. In addition, the 325-day (65-week) exponential moving average sits at $61.80, and was formidable resistance back in December.

The crude chart may be tracing out a very complex inverse head-and-shoulders reversal formation, and certainly not the kind you would find in any technical analysis textbooks. Daily momentum is not yet overbought, so a run up to the recent highs in the $64 area is certainly possible. If this were to occur, we would expect another pause in the rally. The Traders' Commitments report is still showing that commercial hedger's are net long, while large speculators are net short the market. Many times, this has been positive for crude oil prices.

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