Troops Are at the Border
The major indices rallied sharply on Wednesday and Friday, proving that there are other good days in the stock market besides Tuesday. The S&P 500, DJIA, Nasdaq, S&P MidCap 400, and S&P SmallCap 600 all ran up near or slightly above the tops of their respective trading ranges that have been in place since the middle of January. In other words, they are knocking at the breakout door once again, and prices appear like they want to see some different territory for a change.
The potential reversal formations that the indices are working on has gone from looking very sloppy to fairly constructive and symmetrical, a bullish sign, in our view. Depending on how you look at it, the major indices traced out a left shoulder in mid-January or early February, a head in March, and they are currently working on the right shoulder.
Besides the more constructive looking basing pattern, we think trading volume is telling a somewhat bullish story as well. Since the March retest, which occurred on a decrease in volume on the NYSE, activity has been heavier during rallies and light during declines. This is a classic sign of accumulation, and something witnessed during many major market bottoms.
Immediately after the March low, we saw two big up days for the S&P 500 on heavy NYSE volume. This was followed by a three day pullback that saw trading volume evaporate. The market had a huge rally on Apr. 1 on a nice pickup in volume, but that was barely above average. Still, this was a positive, because volume was rising as prices were rising. Then, we saw a consolidation followed by another shallow pullback on anemic volume. That brings us to this week, where we had a nice rally Wednesday on another big increase in volume, but once again, below average. Friday's volume is strong as funds flow back to equities. The next key for volume, in our opinion, will be when the major indices breakout strongly above the tops of their recent ranges. Not only will we want see a pickup in volume from the prior day, but we would like to see it occur on well above-average activity.
We have seen the same volume pattern on the Nasdaq, which is really no surprise to us. The March low occurred on a drop in volume vs. the January bottom. Since the March low, there has been a nice pattern of rising prices being accompanied by rising volume. In addition, pullbacks have occurred on a nice decline in activity.
The growth or more aggressive investment stance, is picking up some popularity as funds have come pouring out of the safety of the bond market and into equities. This has pushed yields on both the short and long end higher, but we think that this is a major positive for stocks, as yields remain very low historically.
There was a panic move into both short- and long-term Treasuries since October, on worries about stocks, the financial system, and the economy. The two-year Treasury yield plummeted from 4.35% in the middle of October all the way down to 1.27% in the middle of March, or right at the stock market's final bottom. Since then, the two-year yield has jumped all the way back to 2.23%, with 55 of those basis points coming in the last four days. The two-year, which was predicting further rate cuts, based on its relationship with the federal funds rate, is now about even with fed funds. According to S&P's Chief Economist David Wyss, some of this move is due to better than expected economic news, and some of it is due to better than expected first-quarter earnings. Whatever the reason, we think it shows money coming out of the safety of short rates and into the stock market -- a very welcome change of events, in our view. Extreme fear is starting to evaporate, and the fixed income market is telling us that the economy is not headed over the precipice as the perma bears would have you believe.
The 10-year Treasury has seen yields spike higher as well, as the whole yield curve has shifted higher. Whether funds are coming out of the two-year or the 10-year, the panic into any part of the curve is starting to unwind to the benefit of equities. Since Apr. 11, when the 10-year finished at 3.47%, yields have risen 27 basis points to 3.74%, and are at their highest levels since late-February. The 10-year appears to be tracing out either a double bottom or an inverse head-and-shoulders bottom. To complete this intermediate-term reversal pattern, yields would have to break above the high in February at 3.92%. Yields have busted above the 65-day exponential average, and this average has been a reversal point for the 10-year since August. The 10-year is approaching key trendline support in the 3.84% zone, and this support line has contained yields since they last peaked in June. If the 10-year completes the reversal formation, which we think will happen, yields could then run up to 4.5% based on the width of the latest base.
The iShares Lehman 20+ Treasury Bond Fund (TLT) is tracing out an ominous looking head-and-shoulders top, and is close to completing this bearish formation. The neckline of this pattern is down near the 91 level, and a break of this support line would complete the formation. The width of this pattern is about seven to eight points, so we could see a measured move from 91 down to the 83 to 84 zone. There is major long-term support down in the 81 to 83 area, so this projection seems like a pretty good target. There have been major bearish momentum divergences on the daily and the weekly charts, a very negative sign. In addition, while sentiment on stocks has been very bearish, sentiment on the bond market has been fairly bullish, another sign that a top was in the cards.
Stocks still have some major overhead supply to deal with, but it certainly feels like we are starting to get better traction climbing the wall of worry.