Wall Street's wearing its rally cap again. Last week, as the Dow Jones Industrial Average climbed to 8745 to rise almost 1,000 points above its July 22 low, everybody on Wall Street (well, everybody who was long the market, anyway) was busy rooting for the rally. Money managers, technicians, investment strategists and market analysts were saying things like, "We may have seen the bottom" and "This rally could go on for a while" and "We may have turned the corner in this long bear market." Could be. But the truth is that no one knows what last week's rally means, and this week hasn't offered a conclusive indication. It could be a rally in a bear market -- good for trading but not good for putting cash to work for the long term. And it could be the first leg of a rally that breaks the downward pattern of the bear. It's important that investors understand the possibilities and the probabilities, and that they don't succumb either to dumb despair or blind optimism. Here's how I'd lay out the possibilities -- and why the probabilities say this is likely to be another rally in a continuing bear market.
Stuck in a Bear Market
The most likely read: Last week's action sets up the indices for a decent run that retraces much of the decline from the highs of last March but leaves us still stuck in a bear market. The Dow hit 10,635 in March, and we could climb all or most of the way back to that number. It's an encouraging sign in favor of this scenario that almost all of the major indices other than the Dow -- the Standard & Poor's 500, the Wilshire 5000 and even the lagging Nasdaq Composite -- are getting ready to test the July recovery highs at the same time. Many technical analysts are predicting that we'll rally to something like 9,650; that would be a "normal" retracing of two-thirds of the ground lost in the drop after that high. A two-thirds retrenchment would be typical of a rally in a continuing bear market. And it would be typical of such a bear-market rally to fall short of the last high. This set of numbers would continue the bear-market pattern of each rally setting a lower high when it fails. To break that pattern, this rally would have to climb through that mid-March high of 10,635 and begin a new pattern of rallies that reach higher highs before they fail. And then we could be reasonably hopeful that this bear market is finally at an end.
Small Battles Reveal Larger War
The odds are against this rally moving the market beyond the bear. There are just too many investors in too many stocks waiting to sell when they've recovered a portion of their losses. It's that kind of battle -- fought over and over again in individual stocks -- that will decide how long this rally runs. For example, take a look at Intel ( INTC), an important leadership stock for the technology sector. In the last few days, Intel has bounced off the bottom of the channel described by an indicator called Bollinger Bands at about $16 a share and then climbed above its short-term, 10-day moving average at $17. That's all to the good, and the stock now has decent upward momentum. (For more on Bollinger Bands, see my story from this spring.) But Intel doesn't have to climb much before it hits a ceiling that will be tough to penetrate. At about $20 a share, the stock touches the top of its Bollinger Band channel (this is the top of the recent trading range for the stock). And at the same price, $20 a share, Intel also hits up against its 50-day moving average. Why is that 50-day moving average important? Remember the technical analyst's saw: Support on the way down becomes resistance on the way up. The 50-day average represents a point where a sizable number of investors bought shares. If the stock were falling, these investors would be reluctant to sell until the stock had breached that level -- no one wants to admit to a loss -- and that price would support the stock. But on the way up, the 50-day and 200-day moving averages represent levels at which a lot of investors would be willing to get out. They'd sell at those prices, because while they'd be taking losses, they also would be about as "whole" as they'd expect to get in this market. So the tops of the Bollinger Band and the 50-day and 200-day moving averages represent a kind of automatic limit on any rally. Moving quickly through these levels requires some kind of solid and exciting fundamental catalyst for the stock or for the stock market as a whole. At the moment, I find it hard to identify a catalyst of that quality.
This problem isn't limited to Intel or to the technology sector. For instance, the same pattern shows up in the chart for Southwest Airlines ( LUV). The stock has rallied from the bottom of its Bollinger Band channel at $11.67 on July 22, but it doesn't have far to go from its recent price of $13.20 before it hits the 50-day moving average and the top of the Bollinger Band channel at $14.62. These charts share another feature besides the immediacy of the top of the recent price channel: All these stocks show dropping price-channel patterns. Not only are they near the top of the trading range, that is, but the direction of the channel -- top and bottom -- is still markedly downward. For these stocks, the most likely kind of rally is one that takes them to the top of the range but fails to reverse the downward momentum visible in the charts. But the reason for believing this rally could have legs -- and that the bear market is ending within the next six months -- is that a significant number of stocks show charts that are much more positive than this. These charts describe stocks that already are at the tops of their trading ranges and that are about to -- or have already -- broken above their 50-day moving averages. These stocks seem poised for a run at their 200-day averages at levels substantially above current prices, and they even have the potential to climb above that resistance.
For example, American Express ( AXP) broke from the bottom of its trading range at $28.66 on July 23 and climbed until it was above its 50-day average with the market action on Friday, Aug. 9. The stock's 200-day moving average is at just $36.77. A move above that level could lead to a substantial run to major resistance at $40 and $45. Washington Mutual ( WM) shows an even better-looking chart. That stock bounced off its Bollinger Band bottom at $32 and broke through its 200-day average at $34.51 and its 50-day moving average at $36.70, and now it is bumping up against the top of its trading range at $38. Of course, charts like those of American Express and Washington Mutual can fail. The stocks can hit the tops of their trading ranges and fall back. But stocks can break out, too. To see an example, look at the chart for Sysco ( SYY). After breaking through the 200-day moving average at $27, the stock has just kept on climbing, pushing the top of the Bollinger Band to $29 in the process. This is one chart where the momentum is now on the upside. Are there enough charts like American Express, Washington Mutual and Sysco to drive this rally at least to the mid-March highs and maybe even higher? Or will the stocks that look likely to fail at a lower level do just that and bring this rally to yet another disappointing failure? Watch the charts for individual stocks. The ultimate fate of this rally will be decided there.