The Market May Have Bottomed

This column was originally published on RealMoney on May 30 at 12:33 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

The major indices look more stable after last week's uptick. I believe that a bottom may now be in place that lasts well into the summer months, and we could see the market climb a wall of worry and return to this year's highs by August.

Don't expect a V-shaped recovery that shoots prices back to the highs immediately: We're likely set for a rocky journey that tests the wills of players on both sides of the market.

First we need to test the unstable rally that ended last week's trading.

With a little luck, the next decline will find strong buying interest above recent support.

My positive attitude is based on the weekly chart of the S&P 500. Bull-hammer reversals just don't get any prettier than the one printed on the weekly chart by last week's recovery. This "big" low will be an obstacle to traders planning on selling rallies as the market tries to move higher.

It is a strong sign that short-side crowding will keep that strategy from paying off well into the summer months. (See first chart below.)

Excess bearishness right now reminds me of April 2005, when the major indices had sold off for two months and convinced everyone that another sharp decline was just around the corner.

But the market had other plans. After several feints to the downside, the indices turned tail and started one of their biggest rallies of the year.

The April 2005 scenario also makes sense when looking at the weekly Market Volatility Index. Notice how it rallied into a test of the level hit during that deep correction and then dropped sharply. This confirms the significance of last week's recovery and the start of a favorable period in which buyers can dip their toes back into the financial waters. (See second chart below.)

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Let me emphasize that I don't expect a straight line back to the spring highs. At a minimum, the major indices need to pull back sharply and fill in the unstable basing pattern. This consolidation would draw in weakhanded sellers for a final shot at taking out support and encourage buying interest by aggressive bulls. In turn, it would set the stage for a catapult off the lows.

Indeed, the S&P 500 looks less bullish on the daily chart than on the weekly. Notice how it shot above the four-day swing high without first testing the three-day swing low. This generates an unstable megaphone pattern that's dangerous for overnight positions until the index prints a higher low. I'm looking for that bounce to start at or above 1250.

Many readers want simplicity in their chart analysis, but I can't help them here. This is a complex situation in which there will be no perfect buying moment. Clearly, positions on both sides of the market need to be well timed to book profits as we head into June and July. But it has been tough to make money all year -- why should now be any different?

The biggest curiosity to me during the selloff was the intimate relationship between energy and commodity stocks and broad-index movement. If you had any doubts that these volatile issues were holding up this year's market, they should now be gone. This lockstep movement points to a bearish resolution after we squeeze out the next recovery.

But now isn't the time to worry about the downside. Instead, traders should be building watch lists of oil service and steel stocks that held up reasonably well in the downturn. Right now, my favorite oil play is Diamond Offshore (DO), which bounced off the 78.6% retracement of its February-May rally last week. This Fibonacci line in the sand often sets up strong bounce trades.

Look for the current bounce to stall early this week and yield to a decline that drops the stock below $80, taking out the stops that are sitting there. A recovery from that price level should yield a rally that reaches $88 to $90. Once again, this is a timed position, in which profits must be taken when the stock moves up to test resistance.

Here are other commodity and energy names that show good upside potential in the weeks ahead: McDermott International (MDR), Weatherford International (WFD), Frontier Oil (FTO), Peabody Energy (BTU), Glamis Gold (GLG) and Agnico-Eagle Mines ( AEM).

Keep in mind that basing patterns take time to form. If past is prologue, we should expect two more weeks of sideways action before the market bounces strongly and tests broken support. Of course, the shorts will pounce aggressively at new resistance, but I think they'll get squeezed hard and provide fuel to lift prices much higher than the current consensus.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Weatherford to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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