A Slow, Painful Recovery for Stocks

Rally attempts are being met with big pullbacks. For major indexes, it will take time for the technical damage to heal

While we still believe the stock market is in bottoming process, it has been a very agonizing time for investors as large advances are sprinkled with nasty retracements. It’s as if the market is stuck in neutral and cannot get any traction either way. Investors seem to be dipping their toes in the water and not liking the temperature.

The technical reason for this type of action is that there was a tremendous amount of damage to many, many charts, and it simply takes time to repair the damage. A large drop is many times followed by a large basing process. So we sit and wait.

The latest rally to fail ran right into a small zone of chart resistance as well as a couple key intermediate-term moving averages. As we have said, the major indexes have a boatload of resistance overhead and it seems to lurk behind every corner. The S&P 500 rallied into a zone of chart resistance that sits between 1317 and 1396. This chunk of resistance is from the recent sideways trading that took place in late January through early March. The recent closing high of 1353 on Mar. 25 took the index right to its 50-day exponential average, while the most recent intraday high was right underneath the 65-day exponential.

If or when the S&P 500 can break through the recent highs, the all clear sign will not going out. Chart resistance from the high in early February at 1396 has to be dealt with. There is also trendline resistance up in that area. Then, there is the potential ceiling between 1400 and 1410 from the pivot lows in August and November. Both the 200-day and 325-day (65-week) exponential averages lie up at 1418 and can be considered longer-term resistance.

Daily momentum traced out a bullish divergence as both the 14-day relative strength index (RSI) and the daily MACD put in higher lows in March, while the S&P 500 was putting in a lower low than we saw in January. However, because prices have stalled, the 14-day RSI has been unable to jump even moderately above the 50 level, and the daily MACD has been unable to move back into positive territory. On the weekly chart, we have also had a positive divergence from the 14-week RSI, a good sign, in our view.

However, the 14-week RSI is still in a very definable downtrend with a longer-term trend of lower highs. The current 14-week RSI looks somewhat similar to the 1989/1990 period and once we had a positive weekly divergence during that bear market, it took another couple months for the market to trace out a final low. The weekly MACD, after getting pretty oversold, is just starting to curl higher and indicates to us that more time is needed to finish the market bottom.

One development of note: The improving price action of the transportation sector. Taking a broad view first, the DJ Transport Index topped out on July 19, 2007, about three months before the S&P 500, Dow Jones industrials, and Nasdaq. Being an economically sensitive sector, we believe the early weakness signaled potential problems with the economy, and of course, worries over high and rising crude oil prices. This is a clear example of the market leading the fundamental news. Looking back, this was a key breakdown for the market, as the transports were one of the sectors that provided leadership during much of the bull market.

The transports put in a key low in January, just like the rest of the major indexes. Interestingly, though, when the majority of indices were retesting their January lows in March, the transports held well above their January lows. What they were doing was tracing out a bullish, inverse head-and-shoulders formation. This pattern was completed this week as the transports broke above the neckline of the formation. They have since pulled back to the neckline, in a test, which can be viewed positively from our vantage point.

The H&S pattern is very symmetrical, giving more credence to it. For instance, the shoulders both came in very close to each other. In addition, the length of time between each shoulder and the middle of the head is almost identical. Also, the rally off the first shoulder and the rally off the head come in fairly close together. What is this strength and outperformance signaling? Just maybe, an eventual improvement in the economy as well as a correction in oil prices. Perhaps things aren’t as bad as they seem after all.

We do believe crude oil prices are topping for the intermediate-term, but think that the long-term trend calls for higher prices. Prices slightly exceeded one of our Fibonacci extension targets of $108/barrel. Since January 2007, crude oil has surged from $50/barrel to $111/barrel without correcting very much. In the process, weekly momentum got extremely overbought and has traced out an ugly bearish divergence. In addition, prices have run up to long-term trendline resistance drawn off the peaks in 2004, 2005, and 2006. Immediate chart support sits in the $86 to $100 zone.

A break below the $86 level could bring additional selling down to the high $70s to low $80s, where more substantial chart support sits as well as some key Fibonacci retracement levels. In the latest Commitment of Traders report, 64% of the positions held by large speculators (dumb money) were long crude oil, a very high level. On the flip side, commercial hedgers (smart money) were short the market by a pretty good margin relatively to the last couple of years. This breakdown in futures positions has been seen a couple times over the recent years, and it has done a nice job of predicting intermediate-term peaks in prices.

A decent correction in crude oil prices would certainly help consumers, as well as market sentiment, and, who knows, maybe it’s the catalyst we have been so painfully waiting for.

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