Stocks Pass a Crucial Test

The S&P 500 held an important support level, a positive sign. Plus: An update on a key Chinese index

The stock market successfully tested the Mar. 5 lows on Wednesday, Mar. 14, and with the impressive reversal seen, it may have broken the back of the bears, at least in the short term.

While the S&P 500 did break below the Mar. 5 closing low of 1374.12 on an intraday basis, the index reversed sharply back to the upside, and traced out a candlestick known as a hammer. When these patterns occur near important support , their implications are many times positive for the market. To complete a potential reversal formation or double bottom, the S&P 500 would have to take out its recent closing high at 1407. If the index can do that, the intermediate-term trend would once again be bullish.

The reversal on Wednesday saw the S&P 500 go as low as 1363.96 on an intraday basis, and we think the index found support from the 200-day exponential moving average that sits at 1367. The index may have also benefited from Fibonacci support as the "500" hit the 38.2% retracement line on an intraday basis Wednesday.

While we think the short-term outlook is much improved, the key for the intermediate-term outlook will be some follow through over the next month or so.

Making a lot of progress in the near term may be tough for the "500" as there is a brick wall of resistance up in the 1407 to 1420 range. This potential short-term ceiling is made up primarily of a glut of downward sloping moving averages. As we have said in the past, when there is a concentrated pieces of support or resistance, many times it is tough to initially get through this area. The 20-day exponential moving average is at 1408, the 30- and 65-day exponential averages come in at 1413, the 50-day exponential sits at 1416, and the 80-day simple average lies at 1420. Chart resistance, from the recent closing and intraday highs, is in the 1407 to 1410 zone. On a retracement basis, a 38.2% take back of the recent decline sits at 1407 while a 50% retracement is at 1417.

On the downside, the recent closing low from March of 1374 and the intraday low of 1364 represent somewhat critical support. While we think there is less of a chance of another breakdown, one must always be cognizant of important supports, especially with the increased volatility that we are seeing.

Our near-term concerns relate to the time, or lack there of, of the latest pullback, and the size of the potential double bottom that is being traced out. Because the downdraft has been so swift, we think there has not been enough time for many sentiment, internal, and momentum indicators to become oversold. The investment polls are still showing generally bullish attitudes towards the stock market. The number of new 52-week lows has not expanded enough to reach levels often seen near intermediate-term lows.

In addition, weekly momentum indicators are nowhere near oversold levels or near levels that have been put in during intermediate-term pullbacks over the last couple of years.

Also, the size of the potential double bottom or base that the S&P 500 is tracing out is so far very small. Many intermediate-term bases are one to three months wide. For instance, the base last May was about three months wide, and led to a very nice advance. Many times, the bigger the price base, the larger the rally that follows. There is a rule of proportionality with regards to the stock market in both price and time. For instance, a huge base that encompasses many years, is many times followed by a very large advance in both time and price. A very long advance is many times followed by a very long and steep decline.

Since the latest rally that started in July lasted about seven months, a pullback of two or three weeks to unwind the excesses that have built up does not seem to be sufficient.

The equity market sell-off has so far been a global affair, with markets from around the world moving in lockstep on a day-to-day basis. The linkage between markets in the U.S.

and in many other parts of the world seem to be getting tighter and tighter. However, for the most part, stock markets around the globe have tended to move in unison from bull to bear markets, from an historical perspective.

Of course, the degree at which they advance and decline is the part of the equation that is different. The one stock market that sometimes leads the U.S. is the U.K.'s FTSE 100 index. However, the FTSE seems to be following our stock market very closely this time.

We think the FTSE, as well as many other global indexes, have traced out at least a short-term bottom. It is possible the FTSE is working on a double bottom or an inverse head-and-shoulders bottom, and its pattern looks very similar to the S&P 500. The index closed at a new corrective low on Wednesday, taking out the Mar. 5 low. However, with the rebound on Thursday, the FTSE is back above last Monday's low of 6058.70.

For a true breakdown, our rule of thumb is a close at least 1% below the prior low that is held for at least two days. Looking back, the FTSE only broke to new lows for one day, and then quickly reversed. So we will keep our eye on the index, looking for a completion of the double bottom before the U.S., or for a breakdown below the recent lows before the U.S.

We remain most concerned about emerging market indexes and our focus has been on China. The iShares FTSE/Xinhua China 25 index (FXI) is consolidating once again, after two major downdrafts. This current correction follows the parabolic rise that took place late last year, and into the high on Jan. 3. The FXI is sitting about 16% off its early year high, and we think is susceptible to further losses.

The most recent closing low on Mar. 2 represented a 50% retracement of the advance since June. That rally catapulted the index to an almost 70% gain in less than seven months. During the price explosion, the slope of the advance got steeper and steeper. This parabolic or asymptotic run is great while it lasts, but is clearly unsustainable.

Once these types of advances crack, damage is many times swift and quite extensive. Because most of the advance was so steep, there is little chart support on the way down. The first piece of any chart support worth mentioning is down in the 80 to 84 range, still well below current prices. Other pieces of potential support come from the 200-day moving average at 88 and a 61.8% retracement of the rally, which targets the 85 level.

The decline off the early year high has come on a huge pickup in trading volume. This indicates to us that investors as well as institutions are bailing out quickly, and the distribution has been quite heavy. This is not a positive sign, in our view.

Longer term, the FXI recently bounced off its 50-week exponential moving average as well as trendline support, drawn off the lows since October, 2005. Both the moving average and the trendline sit in the 90 area, and provided a temporary floor for the index.

Because of the very poor chart formation and the huge volume coming out of the ETF, we see further damage ahead. Any near term strength, particularly if the FXI got up in the 100 to 105 range, would provide another nice selling opportunity, in our opinion. Our next downside target from a technical perspective is in the 80 to 85 zone.

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