Stocks: A Late-Year Bounce

S&P says it appears that the market will be able to finish 2007 on a strong note

The stock market busted out on Thursday, Dec. 6, breaking above key resistance, and completing an intermediate-term reversal formation. Although we're not exactly sure what to call this formation, it does have certain characteristics of an inverse head-and-shoulder. Bond prices fell as we think money started to shift back to stocks, while crude oil prices fell for the second straight week.

The phrase "in the zone" is used many times when describing an athlete who can do no wrong. At the plate, a baseball looks as big as a softball. On the court, the basket looks as wide as a 50-gallon trash can. On the field, a running back sees holes that could accomodate a Mack truck. It's simply a feeling of invincibility. When calling the stock market, one strives to get "in the zone," and when there, one makes every effort to stay there. Once there, you smile more than usual, your chest sticks out a little further, and life is good. However, Mr. Market never lets you stay there too long as he disdains big egos and overconfidence.

There are some market calls, because of a particular price set-up, that we are very confident about because they occur with such high frequency. One of these is that after a decent pullback or correction, the market runs up sharply and quickly to a level where there is a concentration of resistance, and then proceeds to roll over and test the zone near or right at the initial low. This happens so often that we feel absolutely no pressure making this call, as compared to other calls that make our hearts pound and our hands sweat. Well, everything was working to perfection as we ran out of gas right in an area of heavy resistance at the 1490 level, and the S&P 500 started to rollover in what we thought would be a test of the mid-to late-November lows down in the 1407 to 1440 region.

Well, one of the easiest calls we made didn't quite pan out as two small days of losses only took the "500" back to the 1460 level, and then it was off to the races for the market.

One might say that the decline into the Nov. 26 low was a test of the August lows right at the 1407 level. Well, it was, and it was successful. However, after a 10% move to the downside, within the confines of a bull market, the initial low will normally be tested many times, no matter what has happened in the past. So, what now?

We think the breakout above 1490 was significant for a number of reasons. First, 1490 has been a key level for the "500" as both support and resistance. In this case, once this resistance has been taken out in the past, the index has been able to rally nicely. It represented a 50% retracement of the recent correction, sometimes a key piece of resistance. In addition, the 50-day and 65-day exponential average sat in this area as well as the 80-day and 200-day simple average. Not to be left out, the top of the 2% price envelope based on a 21-day simple average also sat right in this zone. So in one day, all this resistance was taken out with a vengeance.

While we believe this breakout was significant from an intermediate-term perspective, the short term could see some backing and filling towards the 1490 level. After a breakout, an index will many times drop back and test this key zone. Besides chart and moving average support in the 1490 area, trendline support off the most recent lows also comes in at this level.

With the rally last week, the S&P 500 has pressed up against a couple more pieces of resistance, so we think is further technical reasoning for a small pullback. The index has run smack into a downward sloping trendline drawn off the intraday highs in mid- and late-October. The "500" ran up to the next key Fibonacci level of 61.8%, and many times this can cause a rally to stall. And lastly, the market is pretty overbought on a very short term basis with the 3-day relative strength index (RSI) up at 84.

So, whether we get the pullback or not, it appears from our perspective that the market will be able to finish 2007 and move into 2008 on a strong note. Chart resistance, from the highs in mid-October, runs up to 1576.

Based on the width of the recent inverse head-and-shoulders, which was 84 points, we could see a measured move to 1574, very close to the October high. Even if the current advance can carry well into January and run up to trendline resistance off the two most recent highs in October and July, this equates to a move into the 1580's zone. Will we note that any major break back below 1490 would throw this bullish call out the window.

When analyzing market sentiment, we tend to focus on charts with the most recent history, perhaps going back three to five years when things get to an extreme. What has caught our eye over the last year or two, and something we have only written about once or twice, is really long-term charts of sentiment indicators, whether they be investment polls or put/call ratios.

During the last bull market (1995 - 2000), the trend in the 10-day and 30-day CBOE total put/call ratios fell from December 1994 until March 2000. This is certainly not earth-shattering as bullish sentiment tends to rise as stock prices rise, reaching a crescendo near the top. During the bear market, the trend in put/calls rose, also expected as bearish sentiment rises as prices fall. That is where things get a bit strange. Although put/calls fell from October 2002 until about January 2004, as stocks rose, p/c's remains in an uptrend and have been moving progressively higher since the lows in 2000. This is an extremely volatile series but the ratios have almost stayed perfectly within this long-term, rising channel.

We don't know why put/calls have been rising during most of the current bull market other than to speculate that it has something to do with the increasing number of hedge funds as this may be one of their favorite modes of hedging against price declines. The one positive we can take from this on a longer term basis is that if the trend in p/c's reverses and starts to head lower, something we would expect to see in a bull market, it can only be bullish for stocks. An increase in call activity vs. put activity causes option specialists to purchase stocks or indices, forcing prices higher.

Well, it's early, but they may be starting to happen. The latest peaks in the 10-day and 30-day CBOE p/c ratios were well below the peaks in August and March. The recent lows in these ratios in October were lower than the prior lows in July. So we have a lower high and a lower low, but still remain in a long-term uptrend. If this uptrend breaks, we think things could get very interesting for stocks.

Bonds got pummeled on Friday, Dec. 7, with the 10-year Treasury yield rising to 4.11% from 4%. In the process, treasuries have completed a double bottom reversal formation, after testing the recent lows this week at the 3.85% area. Last week we noted that yields, on a 17-day rate-of-change basis, had plummeted 62 basis points, the largest since October, 1998, during the Russian default and Long Term Capital Management (LTCM) failure. In addition to being extremely overbought, sentiment was skewed heavily towards the bullish camp. The latest reading from the MarketVane poll showed a further rise in bullish sentiment to 81%, the highest since the major bottom in yields (top in prices) back in June 2003, when yields fell to 3%. A move just back to trendline support would equate to 4.3% to 4.4% on the 10-year treasury.

Crude oil prices fell for the second straight week for the first time since early August. Prices closed at $88 per barrel, and hit $86.20 barrel on Thursday, the lowest level since Oct. 24. Daily momentum is firmly bearish while weekly momentum has rolled over to the downside from extremely overbought territory. We think the current correction will carry prices down to the $70-$80 per barrel area.

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