Potential for resumption of the downtrend increases

Breakdowns in price versus moving averages (both SPX and Nasdaq have fallen below their respective 200-day moving averages) as well as weakeness in the internal strength gauges (particularly a setback in the McClellan Oscillator, which gave a bullish reading last week) have damaged the market rebound from early June lows.

We are less confident that the SPX will be able to retrace 50% of its decline from the April highs (to the 1130 area) and will set tight trailing stops on long positions, hold off from adding longs unless a convincing resumption of the rebound occurs, and gradually add short positions.

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Bullish bias persists

Several indicators depicting internal market strength are assessed each day as we tour through the financial markets.  On Friday, we noticed that the McLellan Oscillator applied to the New York Stock Exchange index crossed up through its 20-day exponential moving average. A cross through this average has previously market intermediate-term turning points in the S&P500 (the last cross was down during the final week of April).  See the chart below (click on the chart to enlarge).

A other indices have firmed and crossed up through important moving averages, we maintain a bullish bias and  will set trailing stops as this rally unfolds.

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Impressive bullish charts despite rally on weak volume

Although volume on this rally has been wanting, most of our sentiment and market breadth indicators, as well as equity index prices relative to their February lows and important moving averages, are solidly bullish.

One highlight is the NYSE Summation Index (NYSI) relative to its EMA 20; note the chart on the Stockcharts.com Market Tour that shows NYSI closing in on crossing up through its EMA 20. In the past, this has identified significant equity turning points. Let's see if that cross comes to fruition.

Small cap equities have also regained favor as risky assets find a bid.

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Improving price and technicals mask light volume and weak intermarket developments

Stocks trading over their 50-day moving averages recently crossed up through their EMA 10, bouncing up from extreme lows (near 5%) not seen early 2009 near the market lows. Put/Call remains cautiously high (a contrary indicator) while the indices base near their February lows.

Sector-wise, our biggest disappointment rests with financials. Their price relative vs. SPX remains in a downtrend and portends risk to this rally. Related to financials, credit spreads in corporates vs. Treasuries are expanding; corporate bonds price relative vs. Treasuries has been weakening and in the past has foreshadowed weakeness in equities.

A curious positive divergence is industrial metals price performance (as seen by copper) vs. bonds. Although copper prices have been falling and bonds rising, RSI has recently favored copper, pointing to a possible short-term trend change.

With these mixed signals, we are not anticipating a particularly strong bounce from current levels. Our high-probability SPX target is 1115-1125 (Friday's close was 1091), or 3% higher.

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Short-term bottoming process continues

The equity markets continue to support our observations noted earlier (see June 6 comment). A few noteworthy considerations:

• The February lows are holding. A continued basing pattern around these lows will enhance the significance of this support level.
• Nasdaq's relative performance has been waning relative to the S&P500, a sign that the risk profile is shifting to the "bluer" chips. Note in our Stockcharts.com Market Tour that small caps performance has begun to trail large caps.
• Typical seasonal strength in June/July
• The dollar, which has trended inversely to stocks, has hit resistance at its April 2009 highs (while MSCI Pacific index finds support at the Q4 08-Q1 09 highs).
• As for market sentiment, the Volatility Index (VIX) closed below the RSI 50 level (albeit slightly) while Put/Call remains stubbornly high (both contrary indicators).
  

Basing pattern in place

SPX remains caught below its 200-day moving average but sits at support at the February lows. RSI is nudging its way higher in a modest positive divergence. Sentiment indicators reached extreme readings (a contrary bullish sign), however, internal damage to the market suggests a need for more time to base rather than an impending bounce in equities.

We track the McClellan Oscillator (NYMO) for signs of market extremes. Normally, we would see a bounce in equities as this indicator rises from an extremely low level. Recently, this indicator hit an extreme low and bounced with little improvement in the equity markets. A similar reaction was seen in Nov 09 when SPX remained range-bound until it broke out in Dec. Put/Call remains at a high extreme (bullish) and likely to trigger a bounce in equities.

Value stocks have recently surpassed growth in relative strength (measured by the Russell 2000 growth and value indices). Small caps have also maintained favor over large caps, although a divergence can be seen as small cap RSI is weakening (and RSI for large caps recently reversed upward from oversold under 30). This could suggest the move into large cap value for safety.

We expect equities to remain choppy and form a longer base before embarking on another leg upward. We expect that any positive macroeconomic or global news will propel the markets higher, and we suspect that negative news may begin to have a more muted effect as equities seek a firm footing.

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