Stocks: The Pain Will Resume

S&P expects that that once this short-term rally concludes, major indexes could fall back to test their recent lows

The stock market is in the midst of an oversold bounce that we think will quickly come to an end. We believe the current rally is a counter-trend move within the confines of an intermediate-term decline. Once this short-term rally concludes, we see the major stock market indexes at least falling back to test their recent lows.

We would use the recent rally to sell emerging market stocks, which we warned about in early January, as well as those stocks that are very extended after the big advance since the June/July 2006 bottom.

On Mar. 8 and 9, the S&P 500 ran up to a key area short-term resistance, and then pulled back. A 38.2% retracement of the recent decline targets the 1407 level, while there is chart resistance from the lows in early January that runs from 1404 to 1416. The intraday high on Thursday was 1407.93 and the intraday high on Friday was 1410.15, right in the thick of this chart and Fibonacci resistance.

It is always difficult to predict how far a counter-trend rally or kickback will travel, but many times, these rallies are limited to 38.2%, 50%, or 61.8% retracements. If the advance can break above the recent highs, the next zone of potential resistance is up in the 1417 area. A 50% retracement targets 1417, and there is chart resistance, from the lows in late January, that come in at this zone.

In addition, the 50-day exponential moving average, which is declining for the first time since July, a negative intermediate-term sign in our view, sits up at 1421. Often, when an index or stock breaks below this key intermediate-term support, the moving average then becomes resistance. A 61.8% take back of the recent decline targets the 1427 level.

One of the many reasons that we think the stock market will run out gas soon and at least fall back to its recent lows is the disappointing trading volume that has been seen during the days the market has rallied. On Mar. 5, when the market hit its recent low, 2 billion shares traded on the NYSE. The first big rally followed on Tuesday on a decline in volume as 1.8 billion shares traded. On Mar. 7, we saw a small pullback followed by a rally one day later on another decline in volume to 1.7 billion shares.

The same pattern can be seen on the Nasdaq. Monday's decline came on volume of 2.3 billion shares. The Mar. 6 rally occurred on a drop in volume down to 2.2 billion shares and the Mar. 8 advance was accompanied by volume of just 1.9 billion shares. In addition, all of these volume levels were well below the levels posted during the big decline on Feb. 27, as well as below levels seen on Mar. 1, another down day. In our view, volume is the fuel for the market, and when it is falling on a rally attempt, it is not a good sign.

Once the rally ends, we see the S&P 500, as well as most other major indexes, heading back down for the all-important test of the Mar. 5 closing low of 1374.12. Many times, a successful price test of an important low is accompanied by a couple of unique characteristics. First, we would like to see a decline in trading volume as the index drops back toward the recent low. This would indicate a reduction of selling pressure by institutions, a positive in our view.

Second, we would like to see multiple positive divergences with respect to momentum indicators as well as internal data. For instance, it would be a bullish sign to see a positive divergence on the 14-day relative strength index, as well as a positive divergence on the number of new 52-week lows on the NYSE and Nasdaq.

Third, we would like to see a strong price bounce off the recent lows that is accompanied by a large increase in volume. While every intermediate-term bottom is different, they do tend to share similar components.

At this point, it is tough to tell whether the stock market will hold near its recent lows or continue to the downside. Because the sell-off basically occurred in a very rapid and dramatic fashion, there have been some extremely oversold readings with respect to momentum, sentiment, and internal data. Many times, we do not see extreme oversold readings until the major indexes are down 7% to 10%, and we have been in a corrective mode for at least a month or two. The 6-day RSI on the Nasdaq, which does react to price movements rather quickly, hit 13 on Mar. 5, the lowest reading since last May. The 14-day RSI fell to 27 on Mar. 5, oversold and the lowest since last June.

Put/call ratios have skyrocketed, with many at all-time highs. The 30-day CBOE put/call ratio hit 1.12 on Mar. 7, eclipsing last May's all-time high, while the 10-day ratio spiked to 1.3 on Mar. 5, also a new high. The NYSE ARMS Index or TRIN soared to 15.77 on Feb. 27, the highest since September 26, 1955. On that particular day, the S&P 500 plunged 6.6% from an all-time high the previous day, a little more dramatic than the current scenario. Another oversold internal reading was the NYSE down/up volume ratio. This rocketed to 100.60, the highest and most oversold reading since October, 1997. That period marked a very quick and sharp decline of 10.8% in only 14 trade days.

So, if the test is unsuccessful, we are looking for maximum downside to the 1300 to 1326 range on the S&P 500. There is little chart support until that area, and the last significant intermediate-term high from last May comes in at 1326. Potential support levels on a break of the recent lows come from a Fibonacci retracement of 38.2% of the rally since June that comes in at 1369. A 50% retracement targets the 1342 level, while a 61.8% giveback is at 1314. Other possible supports come from the 200-day exponential moving average at 1366, the 200-day simple average at 1347, and the 65-week exponential average at 1336.

In addition, extending trendline support, drawn off the lows over the past couple of years, out to the end of April, gives us longer-term trendline support just below the 1300 level. A decline down to 1326 would be 9.2% off the February high of 1459.68.

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