Stocks: A Tricky Road Higher

Major indexes face a fair amount of overhead resistance, which could cause continued volatile trading

The major indexes have all completed inverse, head-and-shoulders (H&S) patterns, in our view, so we believe that the long awaited market low is finally in. However, the indexes still have to deal with a fair amount of overhead resistance, which could cause continued volatile trading, but we think prices will maintain their upward bias off the lows set in mid-August.

The S&P 500 broke nicely above the neckline of the H&S pattern on Tuesday, Sep. 4, completing a bullish, intermediate-term reversal formation. The S&P 500 also broke back above its 50-day and 65-day exponential moving averages for the first time since the latter part of July, another bullish sign, in our opinion.

However, the "500" happened to run right into an area of fairly thick overhead resistance on Tuesday, and then turned immediately lower. As we said a couple of weeks ago, we thought the market was stuck between a rock and a hard place, and so far, it just can't break free. The majority of chart resistance was created this summer, when the index traded between 1490 and 1540.

The S&P 500 has rallied twice into that zone since the correction started, and failed. The first attempt on August 8, well before the final low was in, ran out of gas at 1497. Interestingly, the intraday high on Tuesday was at 1496, right where a 61.8% retracement of the correction comes in. So not only did the "500" run into chart resistance, but it also hit a key Fibonacci retracement level, which can also act as resistance.

Once the index hit the ceiling overhead, it reversed right back to the neckline of the H&S pattern. Many times, after an index or individual stock breaks out from a H&S formation, prices will come back and test the neckline which sits at 1469, right near the intraday and closing levels on Wednesday. So far, so good! Just below the neckline is trendline support, drawn off the lows since mid-August, and that comes in around 1458.

We would like to see the S&P 500 break strongly to the upside on a meaningful pick-up in volume. As we said, volume during the second half of August, when stocks were recovering, was very light. We believe this was seasonal, as many times, trading is the lightest during this time of year.

However, so far in September, volume has not moved back to average levels, and we think a lot of the rally off the mid-August lows was caused by an absence of down volume (selling pressure) and not due to an increase in advancing volume (buying demand).

For instance, since August 17, there have been six days where declining volume on the NYSE was 291 million shares or less. This is way below the 50-day average of 864 million shares, and some of the lowest readings this year. On Aug. 29, declining volume on the NYSE was only 59.5 million shares, the lowest reading since July 5, 2002. This day was basically a holiday since it was a Friday after the 4th. We are seeing the same thing in reverse during down days for the market. Advancing volume just disappears, letting the bears have their way. These one-side days, where either the bulls or the bears step aside, is one main reason we continue to see a lot of choppy activity, in our view.

The Nasdaq completed a head-and-shoulders bottom on Friday, Aug. 31, one day ahead of the S&P 500. The index has also been outperforming the "500" since the rally got started on Aug. 17. The Nasdaq has also broken back above its 50-day and 65-day exponential averages, as well as the Aug. 8 close and intraday highs between 2613 and 2628. The index has very little short-term resistance overhead, and we think should have a clear shot at the July 19 closing high of 2720. The index has also retraced more than 61.8% of the correction, suggesting that we could see a full retracement of the decline.

Volume on the Nasdaq has also been very light, but has picked up quite a bit as we have moved into September. Like the NYSE, there have been some days of late where either advancing or declining volume was basically absent, making it very easy for the bulls to run the index higher, or the bears to take it lower.

Besides the positive price action of the Nasdaq on both a relative and absolute basis, we are seeing some positive developments on the volume side. For the first time since October 2006, we have gotten a buy signal on one of our simple Nasdaq volume models. The model looks at the 6-day and 10-day summation of advancing volume divided by declining volume, and turns bullish when both periods reach a certain extreme. The 6-day summation turned bullish on Aug. 24 and was confirmed by the 10-day summation on August 30. At the end of July, this model was at the most oversold (washed out) level since near the bottom in the summer 2006.

Despite the recent turnaround in the stock market, there has been very little change in the investment polls we monitor. Investor's Intelligence is showing 42.9% bulls and 37.4% bears, almost unchanged from a couple of weeks ago. MarketVane has 53% bulls, also little changed. Consensus has seen an increase in bullish sentiment from 41% to 52% over the last couple of weeks, the only poll that has really moved to a more bullish stance. The American Association of Individual Investors (AAII) poll actually moved to a more bearish position over the last week with 38% bulls and 42% bears. What we would like to see is a pickup in bullishness in the polls that measure what the institutions (smart money) are doing, mainly MarketVane and Consensus, and a continued bearish slant from individuals (dumb money) on the AAII poll.

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