The major indexes have run back to resistance from the March/April lows, but have not yet reached the consolidation levels hit this summer. By disecting the indexes into individual components, it becomes clear that the major large capitalization contributors of the indexes have run into different areas of resistance and therefore, this is a logical place for the market to correct.
Typically, after a major correction in any individual stock, the initial rebound runs out of gas at the first major point of resistance or supply. Those previous buyers, who sat through a very quick and in some instances dramatic loss, now represent potential sellers or supply of stock. These individuals, after recouping their losses, sell to break even. Normally, the market will pullback from these resistance areas before another run can begin.
If the pullback is is not accompanied by major distribution by institutions -- that is, high levels of down/up volume -- and sentiment quickly shifts back to the bearish side, damage will likely be contained to about a 50% retracement of the recent gains. However, if major distribution is witnessed, then a full correction of the gains or retest of the lows will most likely occur.
Up until Monday, Oct. 29, there have been two major days of selling on the Nasdaq since the rally really took off. In other words, the Nasdaq down/up volume ratio has moved up near 5:1 on two occassions. In a stronger market environment, and at the beginning of an advance, this amount of selling is usually not seen. If the 10-day Nasdaq down/up volume moves over 2:1, a retest will probably occur and the bullish volume signals of late September and early October will be negated. As of yet, the 10-day volume numbers on the Nasdaq and the NYSE have not moved over two. But that could happen soon as the down/up volume numbers on Tuesday, Oct. 30, are terrible.
Sentiment has not yet moved back to levels of fear which we would like to see considering the weakness over the last two days. Total CBOE put/call ratios are running well below 1.00 while volatility measures have not really responded to the price weakness. Fortunately, sentiment polls for the most part have not moved back to extreme bullish levels despite the strength off the September lows.
A typical retracement would erase about 50% of the recent gains. This would send the Nasdaq back to 1590, where there is also some chart support. A similar retracement for the S&P 500 would bring the index back to 1028. There is some chart support for the Nasdaq between 1500 and 1625 and 1040 to 1075 for the S&P 500. The chart support is unfortunately minor in nature because the recent advance was so sharp, with little sideways action.
This remains a critical time for the market. Some of the selling over the last two days, and we are just speculating, might be attributed to mutual funds selling before their fiscal year ends on Oct. 31. If the weakness ends today or tomorrow, that would be a sure sign that funds were dumping for tax purposes, taking advantage of the recent strength in many laggard technology stocks.
If, however the selling continues or intensifies, a 50% retracement of the recent gains will turn into a full-blown retest of the Sept. 21 lows. Arbeter is chief technical analyst for Standard & Poor's