Technicals Suggest the Rally Isn't Over

Emotion may have gotten the best of investors last week, but technical analysts argue the charts indicate that the recovery rally may still have some legs, providing those who have missed it so far a chance to participate.
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Emotion may have gotten the best of investors last week, but technical analysts argue the charts indicate that the recovery rally may still have some legs, providing those who have missed it so far a chance to participate.

That's good news for nervous bulls who feared that the two-month run was about to end, and even better news for those underinvested who feared the advance was already over and a downturn at hand.

Since the market dropped to its low in early March, the major U.S. indices rallied sharply higher, climbing more than 30%. However, bulls ran into trouble last week, as the

S&P 500

gave back 5%, and the

Nasdaq Composite

lost 3.4%.

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The explanation for last week's decline varied daily, from normal backing-and-filling to worse-than-expected economic data. For example, Wednesday's 24-point drop on the S&P 500 and 51-point loss on the Nasdaq were pinned to a miserable report on retail sales, which fell 0.4% in April, or 0.5% excluding auto sales.

Other economic data last week certainly weren't encouraging, either. A report Wednesday showed that import prices rose 1.6% in April, the largest increase in almost a year and well above economists' expectations. Inflation at the consumer level was also hotter than many expected, as the core number on the consumer price index, which excludes food and energy, was up a higher-than-expected 0.3%.

The Labor Department's weekly initial jobless claims data showed a 32,000 increase to 637,000, above the consensus figure of 610,000, which came because of layoffs in the auto sector.

Individual stock news wasn't much better. The large number of secondary offerings to hit the market was the easy target, resulting in a glut of shares and not enough buyers. Several companies, mostly financial names, announced common stock and debt offerings, including

Wells Fargo

(WFC) - Get Report

,

U.S. Bancorp

(USB) - Get Report

,

Capital One Financial

(COF) - Get Report

and

Ford

(F) - Get Report

, among others.

Before the end of last week, the bullish chatter that was so loud in April had turned mostly to whispers. But once the exuberance and the doom-and-gloom is cleared away, the charts tell technical market analysts that it wasn't the bad news that swayed the market last week. Instead, it was all a lot of noise that was more of a sideshow than a real market-moving force.

"The advance in March was with a great deal of gusto, and when you create big momentum, it usually lasts for a while," said Phillip Roth, chief technical market analyst with Miller Tabak. "But momentum was waning as we went into May, so now the market has been in a consolidation phase."

In a nutshell, the market was due for a break, says Ryan Detrick, senior technical strategist with Schaeffer's Investment Research. He notes that the S&P 500 came close to breaking through the January high of 943 before running into resistance.

"Simply looking at a chart, throwing out the news from last week, that was the level we expected to take a break," Detrick said. "You can argue that the economic numbers were a disappointment, but looking at technicals, it makes sense where we took a break because we went right up to the 200-day moving average. We went virtually right to it on the S&P, and that's where the rest occurred."

Technical analysis shows that the technology sector, which had been a leader during the two-month rally, came under heavy selling pressure during the previous week.

Apple

(AAPL) - Get Report

shares dropped 5.2% over the last five sessions,

Google

(GOOG) - Get Report

shares declined 4.2% and gave up the $400 level,

Amazon.com

(AMZN) - Get Report

fell 5.6%, and

Cisco Systems

(CSCO) - Get Report

slumped 4.3%.

Roth argues that the selling in tech last week is part of the rotation, and that he hasn't seen any important deterioration in the tech stocks. "The weakest sectors last week were the defensive areas, like utility stocks, and I think that's a reflection of the rotation," he added.

Detrick points that retail and restaurants, two of his focus areas, were hit hard last week but have held up well.

Sears Holdings

(SHLD)

dropped 12.8% over the five sessions,

Brinker International

(EAT) - Get Report

slumped 8.9%,

Target

(TGT) - Get Report

slid nearly 8%,

Best Buy

(BBY) - Get Report

shed 6.6%, and

Darden Restaurants

(DRI) - Get Report

lost 5.3%.

Still, if the technicals are correct and the rally does resume, Detrick says that both areas will continue to move higher.

"We're really focusing on the retailers and the restaurants, which are two areas that have done really well," Detrick said. "They're suggesting that, while the economic data is still bad, the consumer is coming back to life. We still think they're the two areas that, while they have done really well already, will continue to bounce."

The good news doesn't end there, as Roth also isn't sure we've seen the highest point of the recovery yet. His rationale is that nearly every price index, including the

Dow Jones Industrial Average

, the S&P 500, and the Russell 2000, made new highs in the first week of May. So did the breadth indexes and the transports, he said.

"The normal process leading to a bigger correction would be a rally here to new highs by some of the price and breadth measures and not others, creating divergences," Roth said. "It'll take more deterioration before we can have an exploitable decline. It may even take a few months."

Unfortunately, his view is that the market may not see a rally with as much force as the last one. If a new high is made, Roth doesn't expect it to be anything but marginally higher than the January top of 943.

"The seasonals would argue that we trade in a range or make marginal process in the summer," Roth said. "The fall would be the next period where you'd have seasonal vulnerability. So, I'd be looking for selective rotational strength for a while. We could make a marginal new high. Maybe mid-900s on the S&P, possibly even the upper-900s before this recovery is over."

For the longer term, Detrick expects the S&P 500 to break the 940 level and push as high as 1000 or so, which was the November peak. Detrick says that the level for support on the S&P 500 is 875, which is where the index bottomed last week.

"Our view is that we're trapped between 875 and 940 on the S&P," said Detrick. "Whichever one breaks first will be where the next trend will be. But we're of the opinion that it probably will be to the upside still."