The Building Blocks of a Stock Rally

Why signs like diminishing volatility and falling consumer confidence may be signaling a market advance in the months ahead

The major indexes succumbed to some mild profit taking for most of last week after bumping up against the tops of their recent ranges. Since the mid-March lows, most indexes have traced out a series of higher highs and higher lows in a fashion that can be simply described as two small steps forward, one small step backwards.

We are as bored as you with this trading range environment, but it appears that it has a little further to run before the excitement starts.

The baby steps that the markets are taking are slowly diminishing the price volatility that has become so prevalent of late. Many times, when price volatility shrinks, it foretells that something big is coming. With all that we have talked about over the past couple of months with respect to sentiment, market internals, volume, and chart patterns, our guess is that there will be an upside breakout that leads to another sharp but brief increase in price volatility. Once markets get into an uptrend or downtrend, price volatility tends to decrease.

Since October, we have seen multiple days where the S&P 500 fell more than 2%, and recently, have seen multiple days where the index has risen more that 2%. That price jumpiness is slowly starting to contract as the last 2%+ decline was on Apr. 11 and the last 2%+ gain was on April 16. These are the only 2% daily moves by the S&P 500 since Apr. 2.

Is this contraction in volatility, especially those on the downside, indicating that we are past the worst of the credit issues and/or past the worst for the economy? We admit, we don’t know for sure, but we can only make educated projections.

But, according to my beloved boss, Sam Stovall, and a reading of consumer sentiment, there are some signs that signal the worst may be over. Maybe somebody does know. The Conference Board’s consumer confidence index fell to 64.46 in March, the lowest reading since March, 2003. That just happened to be the time of the successful retest of the 2000-02 bear market low. And also represents a period when the stock market was well off its all-time highs, and much more than today.

Sam concluded that whenever the consumer confidence index has fallen below 76 (one standard deviation below the average of 97 since 1977), bad news about our economy’s state of affairs is so pervasive that everyone – even magazine covers – are talking about it. Like the many market sentiment indicators we use, this piece of consumer sentiment data may be telling us what we already thought. This is a great example of where economic data can be charted and used by the technician.

The recent closing high on Friday, Apr. 18, by the S&P 500 was 1390.33, very close to the top of the range hit back on Feb. 1 of 1395.42. The index is knocking on the door, but isn’t hitting hard enough. In our view, the market needs to take a running start. When the markets do breakout, it will be very interesting how much upside can be garnered by the “500” because of the chart pattern that has been laid out since last August. Many times, when you finally get the breakout, and the coiled spring has been released, prices tend to jump quite a bit.

However, just above the recent high of 1395 sits what could be a brick wall of resistance. The major pivot lows last year come in at 1407, and there was a lot of buying from that level on up to the all-time highs. In addition to this chart resistance, trendline resistance, off the closing and intraday highs last year, comes in between 1400 and 1410. Not to be left out, the 200-day exponential average is at 1412. Many times, the top of an intermediate-term base or reversal formation coincides more closely with prior pivot lows, but not this time.

While we believe the stock market will break out of its sideways range, and bond prices will break down from their very wide and toppy looking range, there could also be an intermediate-term trend change for crude oil and gold. Commodity prices as well as commodity stocks have been on fire for much of this year, partly, we think from a weak dollar, partly from the credit crises, and partly as tried and true momentum plays. Gold has already broken down from its uptrend, while we think oil won’t be far behind.

Crude oil prices hit $119.90 per barrel on Apr. 23, and are up from $88 in early February. More shocking, to us, is that crude prices have surged from $50 in January, 2007, without a major correction or extended sideways action. There have only been minor pullbacks during this entire 140% advance. We have raised our targets along the way, often shaking our heads as we did it. Once again, oil is knocking on our most recent target of $122 - $125. A key Fibonacci extension targets $122, while long-term trendline resistance sits up at $125. From a momentum standpoint, crude oil is stretched on a daily, weekly, and monthly timeframe. In addition, there have been some major weekly divergences.

Gold, in our view, has already started to correct after reaching our intermediate-term target of $1000 per ounce. Prices have traced out a head-and-shoulders top, and with a break of the $887 level, this formation will be complete. That would then signal a potential decline for the yellow metal all the way down to the $750 to $800 range. Key long-term trendline support sits in this zone. There is a small zone of chart support in the $800 area but nothing major until the $700 to $725 zone. Major Fibonacci retracement levels target $840, $785, and $730.

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