The Futures / Inter Market Report

Trading the World’s Markets                            

July 27, 2007

                                            
Matthew Caruso, CMT                                  
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The Stock Market in Perspective: a bullish outlook

                What a week for stock traders. The S&P 500 fell more than 5% this past week and closed Friday at the lowest level of the week. Weeks like these are confusing for one reason; investors want to know if this is the start of just a correction similar to what we experienced in February of this year and May of last year, or if it is the start of a bear market similar to 2000-2002. 

            In order to get an answer for such an issue we need to look at the big picture, we need to see this past week’s fall in relation to the bull market in equities that started in late 2002. Figure 1 shows the S&P 500 with 2 trendlines under the price action. The S&P 500 is clearly still in an uptrend. It has not penetrated any significant uptrend lines. This immediately put this week’s sell off into perspective. Until prices fall below the current uptrend line and more importantly the February’s low, this market still has a solid footing.  

Figure 1 Chart by Genesisft.com 

            One concern is that this week’s sell off is the largest since the bull market began. However, does that really matter? This past February had a larger 1 week drop then last March and that didn’t deter the S&P from making new highs a few weeks later.  Figure 2 compares this week’s sell off with several others that have occurred recently. As you can see, it is not unusual for prices to retrace at least 1/3 to 2/3’s of its advances during a correction. In early 2005, prices retraced a little over 50% of the rally that started in late o4’. In March of 06’ prices retraced a little over 62% of the rally that started in late 05’. With prices having only retraced about 50% of the rally that started in February, this correction is not performing any different. Therefore, the first caution signal would be if prices crossed below the uptrend line and more than 62% of the recent rally that started in February. A red flag would need to be raised if prices fall below February’s low. That would change the progression of higher highs and higher lows for the market. The last time that happened was in 2000 and I don’t have to tell you what happened after that.

Figure 2 Chart by Genesisft.com 

            You may be wondering if we have a way to tell in advance if that is likely to happen. Fortunately there is something that can shed some light on the situation. The commercial traders or smart money as some call them, are holding a very large long position. The last time they were this bullish was early 2003 as highlighted with a blue vertical line in figure 3. If you notice, in 2000 the commercial traders had their smallest position ever prior to the start of the bear market, which is also highlighted with a blue vertical line in figure 3. Therefore, the smart money is expecting higher prices for stocks, and with extreme levels of fear in the options market, the market is in a good situation to climb higher in the next few months. Of course all of this does not mean that we will not have another volatile week next week, or that prices won’t fall lower for the next couple of weeks. As stated previously, prices can still fall lower before any caution flags need to be waived. However, this current fall in prices is likely just another correction that will give smart investors a chance to buy shares cheap.

Figure 3 Chart by Genesisft.com                        
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