Rarefied Air for Stocks

October 16, 2006 at 08:00 PM
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The stock market had another good showing last week with the Dow Jones industrial average making new all-time highs and the S&P 500 posting recovery highs. Bond yields spiked higher for the second straight week while crude oil tested the recent lows in the $57 per barrel area.

The S&P 500 rose for the third straight week and has advanced nine out of the last 13 weeks since the middle of July. Since mid-August, the index has remained in a very tight, upward sloping channel. On Thursday, the S&P 500 ran right up to the top of this short-term channel, so in our view, a small pullback in the near term could take place.

In addition, the "500″ has moved to up the top of a longer-term channel that has defined the price range for the index since beginning of 2004. The top of this longer-term channel comes in around the 1361 level. A strong break above this channel would set the S&P 500 up for a move to the 1380 to 1400 zone, in our opinion.

The Dow industrials are in all-time high territory so there isn't any chart resistance to impede the index. However, the DJIA is closing in on potential psychological resistance up at the 12,000 level. Often, major round numbers have provided at least short-term, psychological barriers for the major indexes. Like the S&P 500, the DJIA has run up to the top of a bullish channel that has been in place since early 2004. That trendline (channel) resistance comes in at 11,945.

Since there is no chart resistance overhead, we must use Fibonacci analysis to come up with a target for the DJIA. The width of the correction from May to June was 936.60 points. Multiplying this by 0.618, and then adding this to the top of the formationgives us a potential target of 12,221.52 for the DJIA. Doing the same thing with the S&P 500 gives us a potential target of 1388.84.

The major indexes are overbought on a daily basis, so a small pullback in the near term is a possibility. The 14-day relative strength index (RSI) based on the price action of the S&P 500 hit 72.52 on October 12, the highest since November, 2005. Since 2000, the 14-day RSI has tended to peak out between 70 and 75, although there were a couple of instances when the 14-day got up into the 75 to 80 range.

The positive news concerning the daily RSI is that there has not been any negative divergences yet, suggesting the index has further to travel on the upside. Often, technical indicators such as the RSI will trace out one if not multiple divergences before an intermediate-term trend reverses. The daily moving average convergence/divergence is bullish, but also approaching overbought levels. On a weekly basis, the 14-week RSI is at 67, still below what we consider overbought at 70 or above. It is at the top of the range that it has been confined to since early 2004. The weekly MACD is also bullish, and like the RSI, near the top of its recent range.

What may give the market more fuel for additional gains is the condition of a couple of key sentiment indicators. CBOE put/call ratios remain very elevated despite the strong rally in the stock market since mid-July. Typically, when the stock market rallies sharply, put/call ratios will decline rather quickly. Not this time. One reason may be that put/call ratios got to record levels in May and June. Another reason may be that institutions were expecting the seasonal patterns to play out with the typical weakness in September and October. Obviously, that has not happened.

As option players unwind these bearish bets, and slowly become more bullish, long put options are sold and call options are purchased, adding fuel to the advance. The 30-day CBOE put/call ratio sits at 0.94, down from the record in June of 1.09. However, the current reading is still considered very high from an historical perspective. The 30-day put/call has generally not bottomed out until it fell to the 0.70 to 0.80 range, well below Thursday's reading.

A look at some of the investment polls leads us to believe that the rally also has further to go. Investor's Intelligence (II) poll of newsletter writers is showing 52.2% bulls and 30.4% bears. While there has been a large shift back to the bullish camp since June when only 35.6% of newsletter writers were bullish and over 36% were bearish, the shift probably has further to run, in our opinion. The last major peak in sentiment in this poll was in December, 2005, when bulls marginally exceeded 60% and bears fell just below 21%. Over the last decade, major peaks in the stock market have been accompanied by bullish sentiment that is 30 percentage points higher than bearish sentiment.

Sentiment on the American Association of Individual Investors (AAII) poll is less bullish than the II poll. Bullish sentiment is only 37.8% while bearish sentiment is 46.7%. The numbers in this poll can change quite rapidly but they are currently suggesting that individuals do not have a lot of belief in the markets strength. The last bullish extreme in the AAII poll occurred late 2005/early 2006 when bullish sentiment rose to 59% and bearish sentiment fell to only 16%.

The 10-year Treasury note had another tough week, with the yield finishing at 4.81%, well above the late September low of 4.56%. The 10-year yield has completed a small double bottom and has risen quickly back into a small zone of chart support between 4.72% and 4.85%. A 38.2% retracement of the decline in yields from June to September comes in at 4.82% while a 50% retracement targets the 4.9% level. Chart support becomes more substantial up between the 4.95% to 5.25% area. The daily MACD has turned bullish after getting very oversold, but the weekly MACD has not turned favorable yet as the reversal is still young.

Crude oil prices once again closed lower for the week but continued to hold support in the $57 to $58 area. There have been some positive divergences on the daily MACD and RSI charts, following a deep oversold condition towards the latter part of September. The weekly MACD is still heading lower, and it will be important in our view that weekly momentum starts to stabilize. We are also still looking for some basing/stabilization in prices before calling for an intermediate-term reversal to the upside.

One potential positive is the action of the oil stocks in light of the lack of rebound in oil prices. The S&P Energy SPDR (XLE) has jumped over 6% since late September, and it may be an indication that investors think the price of oil has bottomed out.

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