Stocks: Curb Your Enthusiasm

S&P's Mark Arbeter believes the S&P 500 may be in for a critical test of its recent lows

The stock market, more specifically the S&P 500, fell exactly to the Aug. 16 closing low on Monday, Nov. 26, and then popped sharply higher. While it was a major relief for the bulls, we would keep the effervescence in check, as we wait for what we believe will be a critical test of the recent lows.

After a correction or good-sized pullback, an initial burst higher many times runs out of fuel right near a concentrated area of resistance. The cement ceiling overhead is even more pronounced if many of the major indices run into this concentrated zone at the same time. That appears to be the case so we believe that once the candle burns out on this advance, then the market will roll over and head back to the initial lows.

The major area of resistance for the S&P sits right up in the 1490 area. This level has been both a key area of support for the market as well as an important zone of resistance since early June. It is somewhat amazing how many times this level has come into play over the last six months. It provided a floor for the S&P 500 on two occasions in June, then provided a ceiling for the index during two periods in September. The 1490 level then provided support in October and early November, before once again offering up resistance in mid-November.

Fourteen-ninety has quite a nice ring to it. Interestingly, 1490 basically represents the mid-point of the range for the S&P 500 since the summer. In fact, it is almost exactly a 50% retracement (using intraday high and low) of the recent correction, and once again, becomes a key piece of overhead from a Fibonacci standpoint. Not surprisingly, the intraday high on Friday, Nov. 30, was 1488.94, and we believe this could be the peak of this initial rally.

Besides this important retracement level, the 65-day exponential average sits at 1488, while the 50-day is at 1485. Longer-term averages also come into play as potential resistance with the 200-day simple average at 1484. Of course, there is chart resistance all around the 1490 level, as there has been a fair amount of buying at that level, which is clearly shown by how many times the "500" has bounced higher from this zone. One last piece of resistance for the short- to intermediate term sits up at the 1494, and this comes from the 2% price envelope that sits on top of a 21-day simple average. Many times, the S&P 500 will either pause or turn back after initially running up to this price band.

November, 2007, was somewhat of a rarity as it is the first losing November since 2000, and only the ninth losing November since 1975. Our feeling is that the seasonally strongest month of December will be truer to form, with the majority of gains coming later in the month, following the possible retest of Monday's lows. Since 1970, December has been positive 28 times and suffered only 9 times for an average gain of 1.76%.

We believe the sentiment backdrop supports the case that the worst is over, and once we get the basing out of the way, the market will be able to rally into the New Year. The latest reading from the American Association of Individual Investors' poll is skewed pretty far to the bearish sentiment side, which we believe portends a bullish setup for the stock market. Bearish sentiment has risen to 56%, while bullish sentiment is only 29%. This is the highest level of bearish sentiment since July, 2006, and that was right near an intermediate-term bottom. It is also the third highest level of pessimism towards the market since the bear market in 1990.

The Consensus poll has dropped to a neutral/bullish reading of 50% bulls from 77% bulls in the middle of October. The MarketVane poll is down to 54% bulls from 69% in the middle of October and 74% in May. Bullish sentiment on the Investors' Intelligence poll of newsletter writers has declined to 47% from 62% in the middle of October, while bearish sentiment has risen to 29% from 20%. While these polls have not swung to bearish extremes, there has been improvement.

Put/call ratios have jumped, but have not risen to levels seen during the last two pullbacks. However, we do believe that p/c's have risen enough to support the idea that the low is probably in, and as these high ratios unwind, we think this will support a lift in stock prices. The 10-day total CBOE put/call ratio recently hit 1.14, while the 30-day reached 1.06, a fairly robust level when looking all the way back to 1990. We would have preferred to see p/c's get closer to the levels hit during the last two pullbacks, as this would have shown a more extreme level of fear in the marketplace.

As stocks were getting pummeled during much of November, Treasury bond prices were soaring, taking the yield on the 10-year note back down below the 4% level. The 10-year yield got as low 3.85% on Monday, Nov. 26, right as stocks were bottoming. From Oct. 31 to the recent low, yields plunged 62 basis points. This drop in rates is the largest in a 17-day period since October, 1998, which was during the Russian default and Long Term Capital Management (LTCM) failure. Bond prices are extremely overbought on both a daily and weekly basis, and the price action reflects a panic move that we believe is over. In addition, sentiment towards bonds is extremely bullish. On the MarketVane poll, bullish sentiment is up to 77%, the highest since June, 2005. That period happened to coincide with a major top in bond prices.

Crude oil prices finished below $90 per barrel for the first time in over a month, and we believe that an intermediate-term peak in crude is in. Crude prices dropped $9.53 per barrel this week or about 9.7%. This was the worst weekly decline since April, 2005. The market failed twice to get above the $100 mark, and has traced out a small double top. It was not surprising that the market was unable to take out such a big, round, and psychologically significant level on a first attempt, especially considering how overbought and extended that prices were and how bullish sentiment had become on crude. We think the current correction will carry prices down to the $70-$80 per barrel area.

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