After a stock or index breaks out of a trading range, one of three things can occur. First, the market can keep going, which is doubtful in this market environment. Second, the issue or index can pull back to the breakout point, and then resume its advance. Or third, the breakout will fail and the index or stock will fall back into its trading range to either do some more basing or drop right through the consolidation area and move into a correction. At this point, a test of the top of the recent trading range is most likely, with a resumption of the advance.
Short-term, the market has moved into an overbought condition, so a pullback to support would alleviate this condition. The 6-day relative strength index (RSI) on the NASDAQ has moved back up into the high 70s zone, while the 6-day RSI on the S&P 500 has risen to the low 70s area. The RSI is a measurement of momentum that oscillates between 0 and 100. Since the March 2000 market peak, the RSI levels listed above for the NASDAQ and the "500" represent fairly extreme overbought readings. The major indexes have also advanced back to a downward sloping trendline drawn off the most recent high of May 22, which represents resistance and adds to the probability of a pause/pullback in the rally.
As the indexes correct back to their respective breakout points or into the top half of the recent sideways consolidation, it will be important that the price weakness occurs on lighter than average volume. It will also be positive if the up/down volume breadth does not deteriorate sharply, indicating heavy distribution by institutions. Another positive during any price retracement would be an increase in bearish sentiment as measured by options data and investor polls. If the minor test was successful, then the next ingredient for another run higher would be an increase in volume as the price advances, along with strong volume breadth.
While the market has certainly impressed and surprised a lot of investors since the Sept. 21 low, the easiest and quickest gains are behind us. The fact that many perceive the latest market strength as just another bear market rally is a big positive and vastly different from previous rallies since the market top in 2000. However, there is a fairly substantial area of resistance overhead for the major indexes and the major components of the indexes.
For the NASDAQ, heavy supply starts at 1920 and runs all the way up to the May high of 2300. Resistance for the S&P 500 begins at 1170 and extends up to 1300. This zone of resistance was created by the sideways-to-lower action, that occurred from May until August. Although we do see the market moving up into these resistance areas over the next couple of months, it will take plenty of time to eat through this heavy supply.
Since the bottom on September 21st, the NASDAQ and the S&P 500 have retraced about 50% of their losses from the top on May 22. Previous rallies since the all-time high in March 2000, especially on the NASDAQ, have retraced about 50% of the preceding decline. This occurred during the Spring rally this year and during the Spring/Summer countertrend rally in 2000. Because a 50% retracement is where the market has failed in past rallies and is a common retracement in both bull and bear markets, it is very important for the market to extend its gains past the 75% retracement level, which would give us even more evidence that the worst was behind us and that there would likely be more upside surprises. A 75% retracement for the NASDAQ would equate to 2093, and for the "500", 1223, both of which lie squarely in the resistance zones mentioned above.
We are cautious for the very near term, but somewhat optimistic for the next couple of months. We caution, however, that any advance from here is likely to be a staggered affair and we do not see the type of extended bullish run that was so common during the late '90s. Arbeter is chief technical analyst for Standard & Poor's