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April 26, 2008

The Case for Further Strength

There exist droves of people, in bear's clothing, that believe the rally off the March lows is cooked and is about to turn lower. They cite the fact that the 1400 level on the S&P 500 is a major pivot point. They bicker about how the credit crunch is far from over and is likely to contain deeper surprises (probably true). They claim we are diving into a deeper recession and that stocks will soon reflect this fact. Well, in general I am a bear and believe that a more vicious bear market awaits us. However, there are some fairly potent indications that stocks will continue a bit higher before the bears bite again. Let's have a look, shall we?

Starting with the S&P 500 itself, we see a rally unfolding more or less as I described in earlier posts.

stock chart

As you see, the recent triangle pattern projects us to 1420. However, should the current impulsive move turn out to equal the length of the last, which is very often the case, we should see SPX 1440.

Next, a look at the CBOE Totol Put/Call ratio reveals that it is quite accurate at showing sentiment extremes. The February and August lows of last year, as well as this year's March low, all occurred with the ratio stretching beyond its typical channel. You can also see that sentiment was steadily trending toward bearish all the way from the October high (which showed an extreme amount of bullishness) to the March low.

stock indicator

Sentiment has now broken lower. Whether you believe the current rally is the start of a new bull market or simply the first major countertrend rally in a bear, one would have to expect sentiment to reach a high level of bullishness before we see another major selloff.

The dollar also looks poised for a greater recovery. As I mentioned in a post last week, so many people were looking at the triangle in the dollar chart expecting it to break lower that one simply had to be skeptical.

dollar chart

Sure enough, the dollar reversed sharply higher this week, probably due to intervention, but whatever the reason, the stage is set for a significant countertrend rally, and dollar strength will translate into equity strength in the near term.

The VIX is showing that complacency is coming back in vogue. I am reticent to perform technical analysis on a derivative of the market, but we can at least see that the trend toward higher levels of worry has been broken.

stock market indicator

It's impossible to project how complacent people will get, but I suspect the VIX will drop low enough to thoroughly frustrate bears before stocks see strong selling again.

So how high will this rally go? If I had to take a WAG at it (that's a wild ass guess, for the uninitiated), I'd say we chop our way up to the 1480-1540 area by the elections. I'd also guess that we see a couple quick and dirty selloffs on the way up, just to keep the bears interested. How am I playing things? Well, the inate bear in me won't let me just take a long position and sit on it. I am too wary of the next big shoe to drop in the credit arena. As long as the market continues to behave within the model I just outlined, I intend to just play consolidation breakouts on a day trade basis.


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