Stocks May See a Short-Term Pullback

S&P says that major indexes often retreat to key support areas following a strong breakout

With the volatile third quarter coming to a close, in which we saw all-time highs by quite a number of indexes, followed by a very sharp correction as the credit markets seemed to lock up, and then a nice recovery, we expect a calmer fourth quarter, colder weather, and new highs by many of the major stock market indexes.

In the very near term, we are still expecting some type of pullback, a little larger than the one we had in the early part of last week. Many times, following a strong breakout, indexes will pull back to key support areas and test these breakout points. Besides acting as a price test, these pullbacks alleviate short term overbought conditions with respect to price as well as internal data. In addition, they allow for short-to intermediate-term moving averages to catch up to price.

On a short-term price momentum basis, the 3-day relative strength index (RSI) based on the price action of the S&P 500, reached an extreme level of 90 in mid-September, and is back near 80 late last week. Since the price breakout on Sept. 18, this momentum indicator never cycled back into oversold territory. The last time the 3-day RSI was oversold was in the early part of September. We would like to see this indicator move back into oversold territory and alleviate some of the pressure that has built up with respect to short-term momentum. After this happens, we think the "500" will be set to take a shot at the July all-time high, and eventually exceed this peak.

The NYSE 5-day summation of TRIN or Arms index has also cycled into fairly overbought territory, suggesting that from a market breadth and volume standpoint, a pullback is possible. TRIN is calculated by dividing the advance/decline ratio by the ratio of advancing volume and declining volume. The Arms index shows whether volume is flowing into rising stocks or into declining stocks. If more money is flowing into advancing stocks, the TRIN will be below 1.0 and if more volume is flowing into declining stocks, then the ratio will be above 1.0.

During the current bull market, the 5-day summation of TRIN has tended to oscillate between 7.0 (oversold) and 4.0 (overbought). On Sept. 19, the 5-day TRIN hit 3.79, the most overbought since July 17, which was right near the summer high. While we are not predicting another correction, this indicator has often times alerted investors to the possibility of small pullbacks.

As far as support, there is a lot lumped together in a tight cluster. Chart support lies in the 1490 to 1504 zone. Trendline support, off the recent lows, sits at 1505. The 30-day exponential average comes in at 1492; the 50-day is at 1489 while the 65-day average lies at 1488. The neckline of the inverse H&S pattern is right at 1490.

Despite our expectation for some near-term weakness in stocks, we are still bullish for the intermediate term. From a fundamental view, the bear argument revolves around the dislocations in the credit markets, as well as the deterioration in the housing market. The bulls counter this based on solid GDP growth in overseas countries, and its positive implications for many U.S. companies. We can call this segment "The Haves and Have Nots." Since the market bottom on Aug. 15 to the closing prices on Thursday, Sept. 27, there has been a huge disparity in returns based not only on where you've invested in the world, but also in which sector you've chosen in the U.S.

Over this 30-day period, emerging markets have put up tremendous returns on a relative and absolute basis. For instance, the benchmark of all benchmarks, the S&P 500 is up 8.5% in the last 30 days or from the August closing low. But, the iShares MSCI Emerging Markets Index (EEM) has surged almost 25%. Some of the best emerging market funds have done even better with the iShares FTSE/Xinhua China 25 (FXI) up 48.6%, iShares Brazil (EWZ) up 41%, iShares Latin America 40 (ILF) up 30%, and iShares Hong Kong (EWH) up 29%. On the weak side, the iShares Japan (EWJ) is up only 5% and the iShares Austria (EWO) is up 7%.

From a sector perspective, those that benefit from the global growth story and a weakening dollar have rebounded the most from the August low, while those sectors that are influenced by the turmoil in the credit markets and weakness in the housing market have done the worst. The two best performing sectors over the last 30 days have been energy and materials, both up 15%. Telecom and technology have both risen about 10%.

On the weak side, consumer discretionary is up only 4% and has been dragged down by weakness in homebuilding and retail. Financials, which got hit the most during the summer correction, have only regained 7%, while the defensive areas of consumer staples and healthcare are only up between 5% and 6%. Despite the fact that the major indexes have not recovered to new highs yet, there has been plenty of action elsewhere.

If our bullish call on the stock market plays out, we think money will come out of Treasury bonds, sending yields higher. We think the technical condition, as well as the sentiment backdrop for bonds, supports this forecast. The 10-year Treasury yield has broken trendline support, drawn off the yield highs since July. Daily momentum indicators have turned higher after getting oversold. On the weekly chart, yields have bounced off strong chart and trendline resistance in the 4.3% to 4.4% area. Weekly momentum has also gotten fairly oversold. The Consensus poll hit an extreme of 78% bulls, the highest since the fall of 2006, which was right near an intermediate-term low for yields.

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