Thursday, August 27, 2009

A Trend Interruption (Plus Sentiment)

On Wednesday the S&P 500 rallied 0.01%. However, both breadth and volume ratios were negative. More importantly from our perspective is the fact that the index traded to as low as 1022-1021 during the day. This violated, if only temporarily, the support levels encompassing 1027-1022 that we have mentioned in our last two posts. That was enough, therefore, to lock in the rally from the August 17 low as a complete pattern.

However, we still think that higher highs are likely. There are at least four reasons for that expectation. First the August rally can be counted as a five wave pattern, which suggests that it is the first leg of a larger rally. Second, the S&P has been range-bound for the past three days. This range appears to be taking form of a triangle, which is a continuation pattern. Third, momentum has a bullish bias. Finally, sentiment indicators on balance show more skepticism than belief. So Wednesday’s pressures were likely an interruption rather than a reversal.

Under normal circumstance, the completion of the rally pattern from the August 17 low would imply the potential for a pullback into the 1015-1001 range. We will still keep an eye on that area, but the potential triangle we mentioned above is inherently a trading range and the S&P may not make it to as low as 1015-1001. Indeed, if our count is correct, the triangle may already be in the “D” wave position of its ABCDE structure. So, a breakout to new rally highs could happen sooner rather than later.

Whether or not the index tests 1015-1001 remains to be seen. Regardless, it will take a full blown decline through 979-978 to suggest that something more serious is afoot. The July low itself at 869 is still viewed as tactical support.

Chart and Fibonacci resistance in the 1007-1048 range continues to be an important reference point. However, we have already mentioned that a rally from the 17th would be 61.8% of the prior July-August uptrend at 1070; equality would imply further strength toward 1127 (which is also a 50% retrace of the entire 2007-2009 decline). Moreover, a “second” leg following the completion of the current consolidation/triangle will be 61.8% of the August 17-25 rally at 1058; equality suggests 1081; and a 1.618 multiple would allow for 1117. So arguably we have three bands of resistance that encompass multiple Fibonacci relationships; the bands are 1048-1058; 1070-1081, and 1117-1127.

On another point, our reference above to skeptical sentiment would seem to fly in the face of yesterday’s Investors Intelligence numbers. Several websites mentioned that “II” bulls were over 50% while there were fewer than 20% bears. We have often said that sentiment indicators tend to be trend following and often need divergences (just like momentum) to give serious warnings of a price reversal. Indeed, historically the first overbought peak in the ratio of II bulls compared to the total of bulls and bears has rarely marked the end of a rally. So, we consider to the latest reading to be a yellow light at worst; it is not a red light.

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