Big Swings in Store for Stocks?

With little in the way of strong support or resistance, the market could see some rather large moves in either direction

The major stock market indexes, which seem to be moving in perfect unison of late, pulled back to strong support levels last week, before bouncing higher towards the end of the week. With little resistance overhead, we think things could get very interesting over the next month or two.

The first quarter gave us a little bit of everything from a technical perspective. The quarter began in quiet fashion, with the stock market continuing its pattern of stair-stepping higher with little volatility to speak of. Then came Feb. 27 and the floodgates opened to the downside. It was as if the market just walked off a cliff.

Fortunately, it appears the market hit bottom rather quickly and proceeded to trace out a bullish reversal formation and then break to the upside. Because of the price patterns that have developed over the last four months, there is little in the way of strong support or resistance zones. This creates a price range with little restriction, and, therefore, we tend to see rather large, unconstrained moves.

Sometimes chart patterns are picture-perfect and, therefore, very clear to read. Technicians should be very familiar with these balanced formations because they are the ones that fill most of the technical analysis books that we have read. So far, the double bottom that has developed is one of those picture-perfect patterns.

There was a sharp decline into the initial low that was then followed by a quick snapback that retraced a small portion of the damage. The second low or test occurred on Mar. 14 when the market dropped below the first low but rebounded nicely, forming a candlestick known as a "hammer." Fear ran very high during the test, but the market refused to crack and traced a key reversal right at an important support area. The market then gathered some steam and broke out nicely to the upside on big volume, which was then followed by a test of the breakout point as well as intermediate-term moving averages on lighter volume. These tests of the breakout point are pretty common, and also textbook examples of what to look for during a reversal and breakout.

Looking specifically at the S&P 500, the index pulled right back to a concentration of moving averages in the 1416 to 1418 range. The 20, 30, 50, and 65-day exponential moving averages have joined forces to create a potential floor for the market all within this 2-point zone.

Many times after a breakout, an index will pull back a bit, which allows some time for the 50-day exponential average to play catch up and this is exactly happened. The closing low for the week was 1417, right in the middle of this confluence of moving averages. The intraday low for the week was down at 1409, in between the closing and intraday highs during the double bottom that ran from 1407 on a close to 1410 on an intraday basis.

An area of the stock market that continues to get little respect is the small cap arena. We in fact thought the long run of outperformance of small caps vs. large caps was coming to an end last summer, when relative strength deteriorated quite a bit. However, the relative performance never broke down from a long-term perspective, and the small issues have actually been leading the blue chips since August, 2006. Believe it or not, the Russell 2000 has been outperforming the S&P 500 since April, 1999, or almost seven years. The Russell 2000 has also been leading the Nasdaq since March, 2000.

The Russell 2000's recent action looks much the same as the S&P 500. The index has completed a double bottom formation, broke out nicely, and is now testing its breakout point. The index dropped a little bit more than the S&P 500 during the recent shakeout, which is quite common when the market corrects. The Russell 2000 fell 8.4% in seven trade days, and over a similar period, was just a bit less than the decline last June. The recent closing low of 760 on Mar. 5 as well as the intraday low of 761 on Mar. 14 both found support right at the 200-day exponential moving average. The recent pullback off the Mar. 23 high of 810 has garnered support from the 50-day exponential average at 794.

The index is still above its breakout point of 789, and that represents the next piece of support if the 50-day gives way.

As much as we can gauge, market sentiment towards small cap stocks is fairly bearish. If we combine bearish sentiment with an area of the market that is outperforming on both a long- and short-term basis, it equals a bullish setup, in our view. Asset flows in the Rydex funds are showing a clear preference towards large cap stocks and away from small cap stocks. Many times when this has occurred in the past, small caps provided nice outperformance.

We are also seeing high levels of put open interest in the iShares Russell 2000 Index (IWM), as investors protect themselves from a breakdown in small issues. On the flip side, there is much less call open interest on the IWM, suggesting investors see little hope of a big move to the upside. This combination of open interest provides nice support on the downside and little resistance on the upside, in our view.

One of the many sentiment indicators that we monitor continues to show very low levels of optimism towards the stock market, and many times in the past, this has led to a rally in equities. The ISE Sentiment Index (ISEE), which is designed to show how investors view stock prices and only measures opening long customer transactions on the ISE, hit 59 on Mar. 9, an all-time low. Transactions made by market makers and firms are not included in ISEE, because they are not considered representative of market sentiment due to the often-specialized nature of those transactions.

Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock. When the index is below 100, it is showing that more customers have opened long put options than call options.

With this and other sentiment readings such as put/call ratios showing such high levels of fear and low levels of bullishness, we think a rally may not be far behind.

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