An Ugly Friday and an Important Test

Financial stocks have been weak and some indicators show an overbought market, but it's only a matter of time before the Dow Jones industrial average is back above 14,000

The major market indexes made marginal new highs this week, with the Dow Jones industrial average (DJIA) sneaking above the 14,000 level by the slimmest of margins. Crude oil prices continued to rise, while Treasury yields fell below the 5% area.

As we have seen so many times, whenever a major stock index gets near an important old high or a big round number, we think the chances for a pullback rise. That is what happened on Friday as the DJIA slid from just above the 14,000 area. In addition, with the DJIA's battle, the S&P 500 rose to a new intraday high of 1555.20 on Thursday, marginally eclipsing the March 24, 2000 intraday peak of 1553.11. With both indexes dealing with one form of resistance or another, it was no surprise from a technical view to get some profit taking on Friday.

While we believe that significant price highs are very meaningful, big round numbers or psychological highs are somewhat meaningless, and we think that it will be only a matter of time before the DJIA is back above the 14,000 level. We also believe that intraday highs are much less important than closing highs.

The S&P 500 tested the recent breakout area this week, which is fairly typical. The index fell to 1533.67 on Wednesday, testing the recent intraday high of 1534.26 from back on July 9. However, with Friday's bearish action, we must remain vigilant for a failed breakout. The S&P 500 must remain above the 1530 zone on a closing basis to keep from seeing a breakout failure. Many times, breakouts that don't work can represent key turning points in the intermediate-term trend. Of course, nothing works all the time, and when viewing downside risk for the S&P 500, we think there are a host of moving averages and a layer of decent chart support in the 1490 to 1530 area that must be taken out before the true technical signs will really deteriorate.

For a longer term view, we still believe that the intermediate-term outlook is bullish and the S&P 500 will make a run into the 1620 to 1650 zone over the next couple of months. As we said last week, the index has already reached and exceeded the first Fibonacci extension based on the width of the pullback in February and March. The next Fibonacci target uses the width of the pullback and multiplies this by 1.618 to get an extension of 158 points from the breakout point. This would target an extension of the move to 1620. There is also trendline resistance, drawn off a series of highs from late last year and early this year that would provide resistance up in the 1620 area. There is also a trendline that projects for a potential top up in the 1650+ zone in the later half of August.

The technical backdrop for the stock market is not as bullish as it was a couple months ago, when most of the indicators we monitor were screaming buy. This is what leads us to a slightly more muted stance in the near term. While the market has been extremely resilient of late, a real positive, in our view, the mess in the financial stocks just won't go away and it bears close watching. The financial sector makes up 20.4% of the S&P 500, and is the largest of the nine sector SPDRs. It is the only sector to show a loss this year, and if it continues to act badly, we think it could put a lid on stock prices. Many times over the years, a poor acting financial sector has not been a positive for the overall stock market.

As of July 19, 19 out of 75 stocks in the financial SPDR (XLF) have dropped at least 10% this year, a somewhat disturbing statistic. The XLF was off an additional 2% on July 20 and is very close to testing the closing lows of 34.80 from back in March. A strong break below March's lows would be a bearish technical breakdown, and complete a rather large double top formation. Based on the width of the double top, we could then see an additional downside move for the XLF of about 10%. On a weekly chart, the sector is testing long-term trendline resistance from back in 2005, so needless to say, financials are in an important area technically.

As the market rises, investor's opinions toward the market generally increase. Put/call ratios reflect this increase in optimism about the market as investors raise their exposure to the long side and buy call options. This can be illustrated by looking at the CBOE equity-only put/call ratio. The 10-day equity-only put/call ratio has dropped from a recent high of 0.82 on March 14 to a recent low of 0.54. This is considered an overbought level and is the lowest reading since February 2006. It is never possible to predict how low the put/call ratio will fall during an intermediate-term advance, as this measure fell to 0.50 in July 2005 and 0.49 in January 2004.

One thing that can be said is that at current levels, it is much closer to recent historic lows and, therefore, must be considered overbought. The key to put/call ratios and their influence on the stock market is to watch the overall trend. Many times, an intermediate-term uptrend in the stock market will not end until the trend in put/call ratios reverses to the upside. That has not yet happened.

On an internal basis, we have seen some overbought levels in the ARMS Index or TRIN. The 5-day NYSE TRIN fell to 3.65 on July 17, the most overbought this measure has been since May 18. In an extended market, readings under 4.00 have led to market pullbacks over the past couple of years. The Nasdaq 5-day TRIN dropped to 3.20 on Tuesday, the lowest and most overbought since January.

All said, we think the overriding technical factors are still bullish from a longer term perspective, with the NYSE short interest ratio at an all-time high, individual investors' still cautious, high levels of short interest on the major indexes, and a plethora of media reports that the bull is coming to an end.

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