What's Next, More Rally Or A Major Stall?

08/13/09 09:40:29 AM

by Donald W. Pendergast, Jr.

Even the strongest bull market rallies need time to pause and regroup before continuing higher. Is the current action in the broad markets a consolidation or a major top?

Security: .RUT, .NDX, .SPX
Position: N/A

I was surprised to learn that many investors aren't yet convinced about the validity of the historic March-August 2009 bull market rally; many are still on the sidelines, earning 1% in the safety of cash. As we analyze these charts, keep in mind that at some point, many of those investors are likely to plow their funds back in to the markets, most likely after the market has already embarked on another upleg. Given the long-term cyclical patterns in the broad markets, consider the possibility that such a major flow of money may be the factor that allows the markets to reach the anticipated weekly cycle highs that are projected for mid- to late September 2009.

FIGURE 1: RUT, DAILY. Given the weight of the cyclical and internal strength evidence, the line of least resistance still appears to be up for this index, at least until sometime in September 2009.

Graphic provided by: MetaStock.

Figure 1 is the daily chart of the Russell 2000 index (.RUT). I like to look at .RUT before analyzing the .NDX or .SPX, mostly because of the vital importance of small-cap participation in any sustained long-term market move. The R2K typically makes more dramatic moves (up and down) than either the .NDX and .SPX. We've already ascertained that the R2K made a major weekly cycle low on July 10, 2009, and according to its internal strength readings (new highs/new lows, upside volume/downside volume, advancers/decliners, and rate of change of the index itself), the index appears to be in an extremely bullish posture, with plenty of upside potential. On this daily chart we now examine the daily cyclical action of the index. By most measures, the R2K has already formed a complete daily cycle (measured on a low to low basis) and may actually be poised to start the next phase of a fresh up cycle. The curved blue line traces out the shape of this bull market cycle. The big question: Is this implied cyclical action going to fade into a more sustained period of consolidating price action first? Or might the index instead embark on a major retracement move -- as in lower prices?

Of these three basic directions, up, sideways or down, here is what appears to be the line of least resistance for the R2K. First off, the internal strength readings are still in major bullish territory. For the uptrend to demonstrate staying power, however, the internal strength readings need to move above the red downtrend line, confirming any future upthrusts in this index. Note also that the stochRSI (10) indicator (bottom of chart) is also implying that the daily cycle low may already be in; the real key is to watch the daily bars. If you see a daily close below the trailing volatility stop (black dots on chart set at 2 * ATR10), you may be fairly sure that the index is either going to put in a more significant period of consolidation and/or is going to move lower, retracing a portion of the astounding gains made since early July 2009. Until the chart pattern changes substantially, however, the line of least resistance still appears to be higher for all the big three -- the .RUT, .NDX, and .SPX.

FIGURE 2: STRONGEST FIVE SELECT SECTOR FUNDS. The strongest five Select Sector funds, based on a 13-week rate of change calculation versus the .RUT.

Graphic provided by: MetaStock.

Right now, the strongest Fidelity Select Sector funds (based on a 13-week rate of change calculations versus the Russell 2000 index) are hailing from the automotive, electronics, brokerage/investment management, transportation, and computer industry groups (Figure 2). The five weakest sector funds are found in the following groups: gold miners, wireless, telecommunications, utilities, and defense/aerospace (Figure 3). Depending on the ultimate path of the R2K in the coming days, you may wish to deploy a portion of your funds into the top-rated industry groups on a bullish continuation move. Conversely, if the index breaks down (a daily close below the volatility stop, as mentioned before), consider going short the weakest stocks in the weakest industry groups. Believe it or not, going short the gold mining stocks may actually be a very sound strategy (short term, of course, and for reasons generally unrelated to the price action in any of the broad market indexes) in the weeks ahead, but that's another article for another day.

FIGURE 3: WEAKEST FIVE SELECT SECTOR FUNDS. The weakest five Select Sector funds, also based on a 13-week rate of change calculation versus the .RUT.

Graphic provided by: MetaStock.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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What's Next, More Rally Or A Major Stall?

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