Market Preview: A Rally on Stilts?

NEW YORK (TheStreet) -- The schizophrenic summer continues.

The major U.S. equity indices are all now up in three straight sessions, while last week began with four down days. The overall trend since early June is positive, of course, with the Dow Jones Industrial Average, S&P 500 and Nasdaq back at their early May levels and within shouting distance of their peaks for 2012, but investors looking for substantial upside from here may risk getting greedy.

The analysts over at Bank of America Merrill Lynch have been arguing for a while now that the mega caps will outperform in the hot weather months and that call has been born out but the firm does see some question marks lurking in the technicals.

"This rally could be on stilts," the firm said Tuesday. "Bearish divergences also known as negative divergences are popping up all over in terms of price momentum, breadth, volume and in leadership indices failing to breakout (R2000 [Russell 2000], MID [S&P Midcap 400] and [Dow] transports). This can persist for weeks, but if not reversed this could signal that a pending correction is likely in the month of September."

In the near-term, B of A sees a test for the rally when the S&P 500 reaches the 1400-1425 level and thinks a test of the May 2008 peak near 1440 is possible. The firm puts key support on the downside at 1325.

The S&P 100, which contains the 100 companies with the biggest market caps in the S&P 500, is up more than 14% so far in 2012 vs. the S&P 500's 11.4% appreciation and B of A thinks more outperformance lies ahead.

"We view Mega Caps as the new market leadership," the firm wrote. "Mega Caps represent: Growth, Quality, Yield and Big Bases. The sectors benefiting are Staples, Health Care (primarily pharma), Technology, Discretionary (primarily media) and Telecom. Many of the stocks in the Mega Cap space remain under-owned by institutional investors. Additionally, nearly half of the stocks in the S&P 100 have a statistically significant short position showing investors are fading their rallies. This is contrarian bullish, in our view, as investors don't believe in the rally."

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