Markets & Finance

Stuck in Neutral


By Mark D. Arbeter With many forces at work in the market, both positive and negative, stocks are not likely to make much headway until late in the year. The market is currently in a transitional phase, one which has seen the probable end of the bear market, but which has not brought about the resumption of a bullish trend. The March/April market low was substantial and we believe could be long-lasting. However, the technical damage that has occurred over the last year, especially in the technology sector, will take more time to repair.

The other transition that has taken place over the last year is the rotation out of growth and large-capitalization issues and into small to mid-cap value stocks. While rotation of any kind is usually positive for the market, the major indexes are not likely to benefit, because these smaller issues represent such a low weighting in the top-heavy, market-cap weighted Nasdaq and S&P 500 indexes. For instance, the largest ten stocks on the Nasdaq make up over 30% of the index. And nine of those issues are in the tech/telecom area. On the S&P 500, the 15 largest stocks make up over 30% of the index, with seven issues in the tech/telecom sector. While the rotation into other market sectors does create opportunities for investors, it also limits the upside potential of the major indexes.

Recent action has seen the major indexes move into a consolidative phase following the strong move off the March/April lows. This sideways action has created

support and

resistance areas for both the Nasdaq and the "500" which are important for the short-term direction of the market. The Nasdaq's recent high of 2328 represents resistance while the low of 2000 is support. Short-term support for the "500" lies at 1209 with resistance at 1316. With the indexes near the bottom of these ranges, caution is warranted short-term.

Also, both indexes have traced out small,

head-and-shouldersformations, which have bearish implications down to 1856 for the Nasdaq and 1155 for the S&P 500. This would set the market up for a cycle low sometime in early July and could be the launching pad for strength through August. Beyond that, it is very hard to argue for strength in the September/October timeframe because this period is usually a rough one for stocks. However, weakness in the Fall months usually sets the market up for a strong year-end finish during the November/December time period.

Based on retracement analysis, along with chart reading techniques, the easy gains off the March/April bottom are over. Shifting into the sustainable, intermediate-term uptrend so frequently seen after major downlegs will be difficult. The Nasdaq retraced about 56% of its losses from the January peak, falling between the typical technical retracement levels of 50% and 61.8%. The S&P 500 was able to erase about 78% of its late January to March losses, close to a typical 75% retracement.

More importantly, both indexes moved into the bottom of massive chart resistance levels that will be tough to overcome over the intermediate-term. The strong rally witnessed in January after the Federal Reserve's initial rate cut represents a mountain of overhead supply. All the buying that was spurred on by the surprise rate cut ended up being premature, and as prices move into this zone of resistance, investors will look to sell out of these positions in an attempt to cut their losses. The key zone of overhead supply for the Nasdaq runs from 2250 up to 2892. For the S&P 500, heavy resistance exists from 1275 all the up to 1383. These zones of supply will halt any advance and create an environment of jagged trading.

The S&P 500 remains in much better shape technically than the Nasdaq for a number of reasons. It is much more of a diversified index than the Nasdaq, which is dominated by huge technology issues. While the tech stocks have hurt the performance of the "500", there are plenty of other industries that are acting well to support the "500". The Nasdaq, because of its collapse, has much greater overhead supply than the "500", and its upside is limited because its major components suffered so much technical damage.

The charts of the major technology companies continue to base well below their respective highs, but have not yet broken out of these bases. Some of the major techs have been basing since last October, and therefore could start to break out of their bases at any time. But other techs have only been moving sideways since April and must go through further sideways trading before they are ready to turn higher. The technology group, as with any other market sector, will begin to advance months before their fundamentals turn, but the wildcard is when this will occur.

While the upside potential is capped, we also believe the downside risk is limited. The Federal Reserve's aggressive monetary policy has created a floor under the market. The Fed's concern over the stock market's effect on the economy is very real and results in a desire to support the market until the anticipated rebound in the economy. The problem for the market right now is that the short-term catalyst for the market from the Fed's monetary policy is expected to end shortly, but the economy and earnings outlooks have yet to bounce back. However, if the stock market rolls over again and/or the economy does not show some life over the next couple of months, the Fed is likely to become aggressive again, and provide another shot of adrenaline to the sagging equity market.

Another positive for the market is that cash levels have been building as investors fled the market. This cash on the sidelines is fuel for the market down the road. Some of this cash is being reinvested in the market and there have been some indications that value managers are putting some funds into technology companies.

When value fund managers start dipping back into technology, while growth fund managers continue to pare tech holdings, this suggests that the value guys are comfortable with valuations and are willing to buy the sector they have stayed away from for so long. It suggests that the worst is probably behind us in technology. However, without improving EPS outlooks, the growth/momentum manager is not likely to step up to the plate, and this limits the upside for the group and the market as a whole.

The yellow caution flag is waving for the short-term but the green flag should make its appearance sometime later in the year. Arbeter is Chief Technical Analyst for Standard & Poor's


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