Bottoming theory picks up support, but...

Kevin Pendley | Oct 11, 2008 9:19am EDT | Comment

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Small-cap stocks finally caught a bid with some teeth late Friday afternoon, and rejected a move to 5-year-plus lows with a breathtaking 11.5% rally off that bottom. Was that the reversal manna from heaven that downtrodden stock market bulls have been clamoring for? Here’s the short answer: I like the area we bounced from, but the patterns were not convincing enough to suggest a retest won’t take place.

Unfortunately, the pattern is simply not dynamic enough on weekly studies to say with certainty that the low is in place. Daily charts sport a nice bullish hammer pattern on candlesticks and momentum readings are so oversold that a bounce was more a matter of “when” rather than “if.” Without a more convincing weekly reversal in tow, the market will now need to chop down resistance points and retracement levels of the collapse to add validity to a recovery move that was already a little suspect. Why do I say it was suspect? Because the market was dramatically oversold ahead of a weekend, with a bank holiday Monday and sitting on the risk for a big announcement out of the G7 finance ministers who are huddled in Washington plotting new freebies for financial institutions in hope they will once again open the spigot on lending practices, to as President Bush put it Friday “grease the gears” of the economy. I don’t know whatever happened to the idea of saving for a rainy day, but I suppose that’s a debate for economists instead of chartists.

Now, while I have some reservations about the staying power of Friday afternoon’s startling recovery charge, there were a couple of aspects of the move that truly caught my eye. One is that the rally off the lows was paced – emphatically paced – by small-caps. Before you dismiss that concept as me paying homage to the powers that be at SmallCapInvestor.com remember this: small caps led the way up for most of the noteworthy rallies during the 5-year bull market run from 2002-2007; and more important, small caps led the way DOWN during the recent collapse. How stunning was the underperformance on this historic bearish storm? The spread between the Russell 2000 (NYSE:IWM) and Dow on a percentage basis was at 12.5% three weeks ago. By the close Thursday, that spread had narrowed to less than 1%. If it was dreadful watching large-caps in a tailspin this week, it was truly harrowing watching small-caps getting devoured. If small-caps can start consistently outperforming large-caps once again – even on down days – then I think that will be a potential bottoming (or stabilization) signal that should not be ignored.

OK, so what would it take for the market to confirm that Friday’s lows marked a decisive bottom for equities? From a strict textbook standpoint, the Russell would need to climb back above 649. Now, before you say I’m crazy, that is just too long to wait, you should know that I’m being generous on that projection. I’m taking a Fibonacci retracement of the collapse off the recent highs – not the major record peak. However, isn’t it fascinating that 649 just so happens to be right back on a test of our old critical resistance zone at 650-660 that we were watching so carefully before the dam burst this week? I warned numerous times that a decisive breach of 650 could trigger a sudden quick slide and I can only hope that our readers were able to use that information to their advantage during this week’s difficult, manic and nerve-wracking collapse.

For those of you with a shorter-term horizon wondering about the coming week’s action, here are the key upside points I’m watching:

1) 577 – this area corresponds with a consolidation zone from the spring 2005 correction lows; in last week’s column, I identified this spot as a point to watch if we got through “figure” support at 600; it didn’t stop (or even slow) the market on the way down, but it is still a testing point to watch on the way back up; this also fits closely with a 38.2% Fibonacci of the breakdown range

2) 600 – this is just an obvious “figure” weigh station along the path to recovery

3) 615 – this was a big support point on the October 2005 pullback and also fits with a 50% Fibonacci retracement of the breakdown range

The first thing many of you will notice is that we are still FIFTY HANDLES away from the initial level on that list! Fifty handles used to be the entire weekly range, not exactly a short-term resistance line. If those are my short-term points to watch next week, what gives? As you know, we are experiencing unprecedented volatility, which has generated massive ranges way outside of the norm, which means those points of mine will be on the radar screen if we truly made a noteworthy bottom Friday afternoon. What’s more, when the market goes into freefall mode like it did the last two weeks, it often leaves pockets or “vacuums” of support and resistance zones in the wake. Above 540, there is a vacuum or resistance up to 577.

Now, as much as I would like to lead the cheerleading for all that to matter next week, I think the more likely scenario would be for the Russell to falter either around 550, or near 560 and retest the lows. Without a more convincing reversal pattern in play on weekly studies, building a support foundation makes more sense. While the possibility of a violent rally off a bottom is enhanced by the insane speed of the decline, most major bear market lows require testing to validate the lows as an area of true value. Speaking of value, those of you with one eye on the big-caps might see how the Dow responds around 8000 if it comes into play again. It looked Friday like some investors were pouncing on Dow 8000 as a buying point of value. If it holds up for another test, then it would help the bottoming cause.

Finally, let’s address one more topic. Back in March I wrote about previous recessions dating back since the 1970s and noted that they typically yield a stock market decline on the order of 50%. At Friday’s low, the market was down about 45% -- pretty much close enough in my book. If we can probe that zone again (or preferably hold above those lows on pullbacks) without finding new panic selling, then it would basically fit our target price range for a recession-era collapse in equities. Maybe in a column sometime in the next few weeks I’ll find the time to dust off old charts and we can look at the timing element involved in stock market recovery moves off recession lows.

The table below contains support and resistance points for the Russell 2000 to keep in mind heading into this week’s trading. For long-term traders, some of these key levels may remain in place for weeks...even months at a time. Those with a short-term horizon will lean toward levels that are more immediately in play. As time passes, we will build upon this table with levels that come into focus as important testing zones for trend analysis, and to act as road mark indicators for key reversal patterns.

From a trading perspective, I always keep a printout handy each day of my key support and resistance points for any stock or market I’m trading. It helps remind me of key areas to watch for signs of trend exhaustion, and also for potential entry/exit points for trades.

TECHNICAL ANALYSIS SUPPORT/RESISTANCE POINTS FOR RUSSELL 2000

- 890.16   upward channel resistance on monthly charts off 5-year run;
            also fits with potential upside breakout of congestion zone
- 860.00   projected “figure” resistance off 15-handle testing zones on the ’06 rally
- 856.48   record intraday high set July 13
- 855.77   July 13 close; record high daily and weekly close
- 852.06   Oct. 11 high; bearish reversal peak on daily charts
- 830.01   previous high from the February 2007 peak; key swing line of note
- 815.00   key swing line
- 801.00   congestion resistance zone from November-December 2006
- 775.03   61.8% Fibonacci retracement of the Aug. 2007 peak-Mar. 2008 collapse
- 764.38   new move high set August 15, 2008; approximate double top with June ‘08
- 762.89   previous move high set June 5, 2008
- 760.06   March correction low; key approximate double bottom formation support;
            Near 50% Fibonacci of July ’06-’07 bull run; violated in November ’07;
            Key swingline to watch
- 743.49   previous Aug. ‘07 collapse low; short-term support violated, now resistance;
            Also near chart gap left by Jan. 2008 employment report news
- 726.19   previous double top in June/July 2008
- 720.50   recent trading range swing point
- 700.00   “figure” swing line; no monthly close below here since Dec ’05 until Feb ‘08
- 693.08   20-week moving average; nice trend support for bull run; smashed on
            July/August 2007 collapse
- 685.00   20% decline off 2007 record highs; breached Jan. 2008, July 2008, Sept. ‘08
- 680.94   mild reversal low on daily charts Jan. 28; near 50% of the March ’08 bounce
- 668.58   July 2006 low; important bottom for summer correction; now resistance
- 660.00   short-term downside target on wedge breakout; now swing line
- 654.06   20-day moving average
- 650.00   previous bear market move low set Jan. 22, 2008, former critical support zone
- 647.37   July 15 2008 low; approximate triple bottom with Jan ’08; Mar ’08; snapped
            October 2008
- 643.28   previous move low set Mar. 10, 2008; now resistance
- 614.76   October 2005 bottom; next major chart related downside point
- 606.42   April 2004 highs, now long-term support
- 591.00   50% Fibonacci retracement of the 2002-2007 bull market run
- 577.00   consolidation zone when marketing was bottoming in spring 2005
- 570.06   absolute low on spring 2005 bottom
> 522.48   October 10 close; lowest weekly close since August 2004
- 500.00   logical big “figure” swingline
- 468.31   move low forged Friday
- 458.00   approximate 75% retracement of entire bull market run
- 430.00   figure point near 50% “recession target” pullback

In addition to the print out of support and resistance points to watch, I also like to keep in mind where sudden volatility can spring into the trading mix from the typical release of economic data and Federal Reserve activity.

The market might have other things on its mind this week, but if some of those issues are sorted out Monday and Tuesday, then we’ll also get a wave of fresh economic data running the gamut from consumer spending, inflation and manufacturing. What’s more, there is a litany of Federal Reserve speakers on the agenda, highlighted by Chairman Ben Bernanke on Wednesday. If things weren’t so insane right now, Wednesday would typically be a huge day for the market, with retail sales and Bernanke on tap, but we’ve moved way beyond “typical” the last couple of weeks.

The table below highlights calendar event risk for the week, with the emphasis on various economic reports. Our table below has a special “Risk Factor” designation, which is simply my assignment of risk to that event, ranging from 0 to 5, with 5 marking the highest risk for volatile market swings.

CALENDAR EVENT RISK ASSESSMENT FOR THIS WEEK

RISK FACTOR REPORT/ITEM (all times Eastern) Consensus

0           Fed’s Hoenig bankers annunal meeting (Mon., 8:00 a.m.)
0           Fed’s Plosser intro at Zambia program (Tues., 12:30 p.m.)
1           Fed’s Bullard at Memphis econ club (Tues., 8:00 p.m.)
2           Fed’s Yellen on econ outlook (Tues., 10:00 p.m.)
4           PPI (Wed., 8:30 a.m.)                                                -0.4%
5           Retail Sales (Wed., 8:30 a.m.)                                     -0.6%
3           NY Manufacturing Survey (Wed., 8:30 a.m.)                    -10.0%
1           Business Inventories (Wed., 10:00 a.m.)                           0.5%
5           Fed’s Bernanke on econ outlook (Wed., 12:15 p.m.)
3           Beige Book (Wed., 2:00 p.m.)
2           Fed’s Kohn on the economy (Wed., 7:00 p.m.)
4           CPI (Thurs., 8:30 a.m.)                                                  0.1%
0           Fed’s Bullard at annual policy conf. (Thurs., 8:30 a.m.)
3           Weekly Claims (Thurs., 8:30 a.m.)                               470,000
2           Industrial Production (Thurs., 9:15 a.m.)                          -0.8%
3           Philly Fed Survey (Thurs., 10:00 a.m.)                            -10.0%
0           Fed’s Stern speech TBA (Thurs., noon)
0           Fed’s Rosengren on housing (Thurs., 10:00 p.m.)
3           Housing Starts (Fri., 8:30 a.m.)                                    875,000
1           Michigan Sentiment (Fri., 10:00 a.m.)                              67.0%
0           Fed’s Bullard moderates policy panel (Fri., 12:45 p.m.)
1           Fed’s Evans on econ outlook (Fri., 2:00 p.m.)