Stocks: A Steady Grind Higher

S&P advises patience with equities, as it expects crude oil prices to continue to fall, and bond yields to carry higher

The stock market bounced off key support areas last week, but considering the large decline in crude oil prices, we think the price action was less than robust. In addition, stocks did not seem to benefit much from the recent breakdown in Treasury prices, as we thought a less defensive stance by investors would have given stocks a bit more juice.

We expect crude oil prices to continue to fall, and bond yields to carry higher, so we would be patient with stocks, as we see indexes grinding higher for now.

In our last column, we painted a pretty bearish picture for crude oil, and the market cooperated last week with prices falling $5.79 per barrel, or 4.3%, to $127.38. In the process, crude knifed through a very steep trendline off the early May lows, and looks set for additional losses. The first area of support comes in around $120. That level represents a pivot high in April with a layer of chart support that runs down to the $110 area. In addition, intermediate-term trendline support, off the lows since February, also points to the $120 level as initial support.

However, because crude oil is so extended and overbought, and has not really corrected during its historic advance from $50 to $134, we expect more than just a pullback to the $120 area. Substantial chart support does not come until the $100 to $110 zone. In addition, longer and more significant trendline support is also in this range. A 38.2% retracement of the advance since early 2007 targets this range as well. Finally, the 65-week exponential average, which many times acts as support during long-term up trends, will be in the $100 to $110 range in about a month or so.

A couple of times last week, it appeared that the stock market was going to move nicely higher, especially the way crude was falling, but that was not in the cards. We think there seems to be a real hesitancy by investors to jump back in with both feet. How long this lasts is anyone’s guess, but at least, we haven’t been heading lower. Until volume starts to come back in, this chop higher is probably the best we can expect.

One thing that may be holding stocks back is the continued dreary action of the financial stocks. Intuitively, the health and price action of the financial stocks has a large bearing on sentiment towards the overall market, especially in light of the credit crises that has hit Wall Street and Main Street.

Without a healthy or at least improving financial system, we believe stocks will be capped on the upside. In addition, the financial sector is the second largest among the nine sector SPDR’s with a weighting of 16.1% of the S&P 500. The sector trails only technology which represents 20.1% of the “500.”

The XLF or Financial SPDR is dominated by the largest banks, insurance companies, and investment banks in the U.S., with the top 10 holdings representing 45% of the index. The largest are Bank of America (BAC), JP Morgan Chase (JPM), Citigroup (C), American International Group (AIG), Wells Fargo (WFC), and Goldman Sachs (GS). A look at these six stocks reveals a list of companies struggling to trace out a bottom. The XLF is attempting to put in a bullish reversal pattern that could potentially end up being an inverse head-and-shoulders formation. Prices are currently testing the intraday lows of the left or first shoulder in the 24 area. If this zone is taken out, then it looks like a full retest of the March lows will occur down between the closing and intraday low of 22.9 and 23.45.

If this last bit of support is taken out, something we do not see, the next area of chart support comes from 2002 bear market lows between 18.5 and 20.

The sector has severely underperformed the S&P 500 since February 2007, and hit a new relative performance low for the move this week. Some of the individual components of the sector are showing more severe underperformance than they did during the 2000 to 2002 bear market, while the length of declines on some is also longer than the last bear market. This may be a big reason that the water remains too cold for investors to put both feet in. Historically, major collapses in individual stocks as well as indexes take many months if not years to reverse themselves, so the bases end up being rather large and full of false starts.

The small rally by the S&P 500 last week started from a fairly important area of support. Chart support, from the recent breakout zone, sits in the 1370 to 1380 range. A 38.2% retracement of the recent rally comes in around the 1370 level. The 50-day simple and 65-day exponential averages also lie in this area and many times act as support following a major breakout. The index also fell right to the lower part of a 21-day envelope shifted vertically by 2%. While we think the recent lows will hold, a breakdown from here would have bearish consequences, in our view, and suggest that the lower part of the early year double bottom will be tested. As we said, the price action has been tentative at best, so the near term moves will be an important indicator to what might happen over the intermediate term.

The 10-year Treasury yield broke out to the upside last week, and in the process, completed a double bottom reversal formation. The width of the pattern is about 65 basis points, so we could potentially see a measured move in yields up to the 4.6% area. There is little chart support until yields get up in the 4.3% to 4.7% range. A 61.8% retracement of the decline in yields from June until January targets the 4.5% region. Our feeling is that a yield breakout would be partly due to a potentially large asset allocation out of defensive investments like bonds and into more aggressive investments such as stocks. We remain patient!

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