Stocks Break Through

The S&P 500 has passed through a zone of heavy chart resistance and is in good shape to extend its recent gains

The Federal Reserve cut interest rates more than most expected on Sept. 18, leading to one of the best days in years for stocks. With the aggressive rate cut came a chorus of worries about inflation as the U.S. dollar fell sharply, gold, oil, and other commodities rose sharply, and longer-dated Treasury yields rose.

All this excitement in a few short days, and it isn't even October yet.

The 2.9% surge by the S&P 500 on Tuesday, Sept. 18, was the largest one-day gain since March, 2003, just when the market was coming out of its last and final low of the bear market. With the Fed-induced gain, we think the "500" laid any doubts to rest that the inverse, complex head-and-shoulders (H&S) that we have been talking about, has finally been completed.

In the process, the index passed through a very thick zone of chart resistance in the 1490 to 1504 area. With the heavy lifting out of the way, we believe the stock market is in good shape to extend its recent gains during the seasonally strong last quarter of the year, and into January, 2008. The remaining chart resistance for the S&P 500 is rather thin, in our view, and runs up to the July closing highs of 1553.08.

With the completion of the H&S bottom, and based on the width of the formation, we could see a move up to the 1600 area over the intermediate term. Ironically, this has been our year-end 2007 target since the end of last year. There are two more targets that we would like to examine, and they are a bit more aggressive. If the S&P 500 runs up to the top of the bullish channel that has been in place since last summer, by the middle of January, it would target the 1650 level. Interestingly, a Fibonacci extension, based on the width of the correction, targets the 1644 zone.

Over the very near term, we think the chances of a minor pullback are pretty high. When an index breaks strongly out of an intermediate-term reversal formation, prices get extended from their 65-day exponential average. Many times, prices will then pause, allowing the 65-day average to catch up. As of Thursday's close, the "500 was 2.5% above its 65-day average. The index also got very overbought on a short-term basis. The 3-day RSI hit 90 on Wednesday, suggesting that the rally may pause with prices backing and filling a bit. Finally, following many breakouts from bottoming patterns, an index will pullback towards its breakout point. In this case, that would equate to a retracement back near the 1500 level.

The CBOE volatility index (VIX), which measures market expectations for near-term volatility based on option premiums of the S&P 500 index, has traced out a H&S top, confirming to us that the market's intermediate-term trend has turned back to bullish. We do not like using the VIX as a leading indicator of what the market might do, but rather we use it as more of a confirming or coincident indicator. The way the VIX is constructed bears this out. Option premiums follow stock prices, and generally only widen as price volatility increases.

Besides the topping action, there have been a couple other related positives from the VIX. Many times, after a spike higher, the VIX will trace out a lower high sometime during the bottoming pattern for stock prices. The high for this move occurred on Aug. 16 which was then followed by a lower high on Sept. 10. On Tuesday, when the market soared, the VIX fell 23%, the largest one-day decline since June 15, 2006, right near the bottom of that intermediate-term pullback. In addition, the spike on Aug. 16 by the VIX was not confirmed by some daily momentum indicators. The 14-day RSI put in a lower high at that point, a negative price divergence. This divergence is often seen at the peak in volatility and near the lows in the intermediate-term price patterns.

The U.S. dollar index closed at 78.60 on Thursday, almost equaling the all-time low of 78.33 set in September, 1992. We have data back to November, 1985. Basically, below long-term support at 80, we are in unchartered waters for the U.S. greenback. The euro and Canadian dollar made all-time highs vs. the dollar last week, and there does not seem to be an end to the bear market for the dollar. The U.S. dollar is oversold on a daily, weekly, and monthly basis. Sentiment is very bearish for the greenback, while the smart money is net long and the dumb money is net short. While the price pattern looks terrible, the other technical conditions continue to suggest that at least an intermediate-term bottom is near. This is kind of hard to believe as there doesn't seem like there is much that can help at this point.

While the dollar was falling last week, commodities like gold and oil moved sharply higher. Gold broke out above last year's high of $725 per ounce, and is quickly closing in on its all-time high of $850 set back in 1980. With the break of the 2006 high, we think that gold prices are set up for a move to $825. This target is based on a Fibonacci extension. Prices are overbought on a daily basis but not on the weekly charts, suggesting more upside is possible. The one potential negative for gold prices is that sentiment is extremely bullish. In addition, large and small speculators (dumb money) are getting increasingly long while commercial hedgers (smart money) are net short.

Crude oil is in a similar situation as gold prices. The trend is strong and overbought, but there have not been any negative divergences. However, sentiment towards oil and oil stocks is very bullish. Crude did run into some pieces of technical resistance in the $83 to $84 area, so we would not be surprised to see a pullback. Until the dollar bottoms out, we think these commodity trends will remain in place.

Before it's here, it's on the Bloomberg Terminal.