Successful Test of the Lows

Once this consolidation runs its course, we believe the S&P 500 will bolt to all-time highs

The stock market tested the recent price lows during the middle of the week and so far, important support levels have held. The bond market, which has been giving the stock market some problems, settled down, with yields on the 10-year Treasury much closer to 5% than the recent high at 5.25%. Crude oil finally broke above $70 per barrel, and appears headed back towards last year's high.

On Tuesday, the S&P 500 closed at 1492.89, just above the recent low posted on June 7 of 1490.72. The closing low this week was also the site of the 65-day exponential moving average, which many times provides support during an intermediate-term uptrend. On Wednesday, the index put in an intraday low of 1484.18, representing a false break to the downside.

While the S&P 500 still remains rangebound between 1490 and 1540 on a closing basis, considering the heavy flow of negative news over the past couple of weeks, we think the market is acting pretty well, and once this consolidation runs its course, we believe the "500" will bolt to all-time highs.

As we have mentioned many times in our commentaries, the slope of the current bull market steepened after the bottom in the summer of 2006. If the recent lows hold, and the market takes off again, the slope will have steepened for the second time. Higher angles of ascent can last for awhile, and are definitely profitable on the way up. However, if the slope gets too steep, that is usually a good warning that we are seeing an upside blowoff. These, unfortunately, can end badly. We are not there yet, in our view, but it is something to watch for later this year if the market gets cooking.

The reason the slope of the bull market has steepened is because each successive pullback, beginning with the one in May 2006, has been shallower in price and shorter in duration. The pullback from May 5, 2006 to June 13 (only looking at closing levels) knocked the S&P 500 back 7.7% and lasted 26 trade days. The next pullback from February 20 to March 5 dragged the index down 5.9% and lasted nine trade days. If the current pullback is over, as we hate to assume anything, it only lasted three days and the damage was limited to only 3.2%.

Because the latest pullback was limited in price and time, it has not allowed daily momentum indicators to cycle into oversold territory. The momentum low for the recent dip, using the 14-day relative strength index (RSI), occurred on June 7 with a reading of 41. Typically, during an intermediate-term pullback, the 14-day RSI will drop to 30 or below. This is what happened in June 2006 and March 2007.

We can read this lack of oversold momentum a couple of ways. On the bullish side, a market that can alleviate an overbought condition without limited damage is exhibiting strong characteristics. As we said, many times intermediate-term declines tend to see greater price declines and take longer as the froth is wrung out. Each decline that sees less price erosion has to be hurting the psyche of anyone who is short the market or any option investor loaded up with put options. The bullish case argues for another blowoff to the upside as those bearish on the market potentially throw in the towel.

On the bearish side, and this is more minor than the bullish case, the market usually sees its best upside moves after momentum cycles into oversold territory. The market gets washed out on the downside with fast pullbacks, and this creates an absence of resistance on the way back up.

Speaking of those that are on the wrong side of the bull market, and represent future demand for stocks, the NYSE Short Interest Ratio hit 8.0 recently, the highest level we have ever seen. We have data on this ratio back to 1943. While the increase in hedge funds has elevated this ratio since the mid-90s, it still represents a bearish take on the market and eventually these shorts will have to be covered. With each pullback that does not turn into a correction, or something worse, the pressure builds on those that are short. While the theory that an investors risk is unlimited on the short side is incorrect, as nothing can go up forever, the time will come when the shorts throw in the towel and cover. We believe that will be a sign that a bull market top is approaching.

Of the three major U.S. indexes (S&P 500, DJIA, Nasdaq), the Nasdaq has pulled back the least from recent high to low. The heavily-weighted technology/telecom index has only seen a relatively minor 2% dip, and is fairly close to its recent high. Not only is the Nasdaq well represented by the tech and telecom sectors, it is also heavily-weighted toward just a few large cap names. The top 10 stocks as far as market cap represent 27% of the index, while the top 20 make up about 38% of the index.

This smaller pullback vs. the other major indexes is rare, as the higher beta index usually goes down further during pullbacks and corrections but goes up more during intermediate-term advances. In fact, since the middle of May, the Nasdaq has been outperforming the "500." This is a noticeable change in character and may suggest that we might finally get some longer-term leadership from this index.

Crude oil closed above the $70 per barrel level for the first time since last August and prices are in the last piece of overhead resistance that runs from $68 to $77. Prices have now retraced over 61.8% of the decline from July to January, which suggests that a full retracement back to the old highs of $77 is possible. Both daily and weekly momentum are still pointing to higher prices, in our view, and neither is in overbought territory. While crude has broken out to the upside, gasoline prices look toppy after running up to major long-term resistance. Daily momentum has rolled over, while weekly momentum is close to turning lower.