Don’t Chase This Rally

Barron’s

Notwithstanding Wednesday’s monster stock move, stocks have formidable resistance ahead on the charts.

The eye-popping surge in risk assets from stocks to commodities to high-yield bonds at the opening of Wednesday’s session covered the faces of the bears (mine included) with a generous coating of egg. And while the Standard & Poor’s 500 punched through key short-term levels on the charts, the technical condition of the market is still far from bullish as heavy resistance lies not far above current prices.

When the market moves as it did this week, it is difficult to keep up with short-term changes. To cope better, we need to look at long-term charts.

Let’s start with the good news. One may argue the 2011 decline merely marked a correction in a long-term bull market. If we look at a weekly chart, we will see a similarity to last year’s drop and resulting multiweek trading range (see Chart 1).

Chart 1

STANDARD & POOR’S 500

[GT1-1130]

The shapes of the two trading ranges are also similar with the middle of three price troughs being significantly lower than the others. And the rallies from respective third lows started with explosions of buying.

In September 2010, when the index rose above resistance from the prior month’s high, there was no denying the bull was back. Similarly for this year, if the index can now rise above its October high then the bulls will have powerful supporting evidence.

But the bears still have a few powerful arguments to put forth and they are already in place.

The first is that overhead resistance is quite strong. Resistance is an area on the chart where supply overwhelms demand and prices stall, if not retreat. From January through July of this year, the Standard & Poor’s 500 moved sideways in a giant trading range and arguably was stopped on seven different occasions in a zone surrounding 1350.

The bottom of that range was roughly 1260 and when prices moved below that level in July they plunged.

Both of these levels, 1260 and 1350, are very strong technical levels. With the index trading at 1236 Wednesday afternoon, it is just now starting to reach this massive band of resistance.

In order to explain how this will affect the market, consider the analogy of a car driving through a large puddle of water. If the puddle is just wet road surface–which would offer weak resistance—the car’s speed won’t be affected.

But if the puddle is several inches deep–with strong resistance—the car will slow down. The car may make it through to the other side of the puddle and continue on; indeed, if the puddle is deep enough, the car will stall.

In my view, the 2011 trading range is a rather deep puddle, meaning that it offers very strong resistance—far stronger than that encountered after last year’s breakout.

Another factor against the market now is volume, which seems rather light considering the size of this week’s gains so far.

While volume has been a contentious feature in recent years, owing to the rise of exchange-traded funds and off-exchange trading, we can still use it to see if there is power behind the price move. According to Richard Wyckoff, a master technician of a century ago, price movement and volume should be in harmony. That means the effort expended by the market—volume—must be commensurate with the result—price movement.

Even taking overall volume levels with a grain of salt, the movement in price this week has not been supported by a large increase in volume. The fuel for the rally, in traditional terms, is not there.

To be sure, the bulk of this week’s gains was sparked first by hope and then action with regard to shoring up the global financial system. As long as central banks are willing to print money, then stocks will have an alternate source of fuel.

But once the flood of central-bank liquidity stops, as it did just before the 2010 market peak and again just before the 2011 market plunge, the charts suggest there will be nothing organic left to keep the stock market’s gains going.

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