Reality Check for the Four-Week Rally

04/06/2009 11:23 am EST

Focus:

Jim Farrish

Founder and CIO, Jim's Notes

Jim Farrish, editor of SectorExchange.com, says risk is rising following the markets’ big rally.

Just as investors start to be believers again, the stock market’s robust rally could get a dose of cold reality: Earnings season begins Tuesday with Alcoa’s (NYSE: AA) report on its first-quarter performance.

The broad market indexes finished another week of solid gains last week, with the Standard & Poor’s 500 index up 3.2% and the Nasdaq Composite index up 4.9%. But is the rally sustainable? Earnings season will be the real test of whether this is a technical bull rally in a bear market or a trend shift to a new bull market.

Last week, I wrote that the S&P 500 index looked like it has a “V” bottom pattern, or a reversal pattern in technical analysis. The bulls have been pointing to the end of the bear market and declaring a trend reversal. Last week’s trading only added credence to their argument. It could very well be true, but you still have to practice disciplined trading. Let your profits run, but keep your stops in place.

Scanning through the market sectors, we find plenty to like: Seven of the ten major sectors of the S&P 500 index are bullish and three are laggards. Of the seven leaders, technology, financials, and telecom have set the pace. Each will play an important role in determining the longevity of the current rally in play.

(This week’s table, updated nightly on SectorExchange.com, has been expanded to show some of the subsector ETFs that are breaking out technically.)

The Nasdaq 100 index has been impressive, showing solid leadership over the last four weeks. Last week, it broke above the key resistance point of 1285. The close on Friday was 1316, and technically, the index looks bullish. If the fundamental data confirms the move higher, this index could be the core leadership in any trend change in the broad market.

The Dow Jones Technology Index also took out key resistance at 392, breaking higher on good volume. This is the leadership for the broad market and a key indicator for its direction near term. The 20-day moving average moved above the 50-day moving average last week, indicating a bullish trend emerging.

A glance at the weekly chart also shows a bullish double-bottom breakout. The longer- term chart showing bullishness is something we haven’t seen in quite some time. This is worth watching for confirmation of the up trend. 

Industrials, basic materials, and transportation continued their moves higher after pulling back early in the week with the broad market. The retail index broke above resistance at the 300 level and moved above the 200-day moving average. The strength is coming from increased confidence in the market and some better-than-expected sales data. This is another sector worth watching in the short run.

Health care was a laggard last week, giving up 1.8% for the week. The Dow Jones US Healthcare Index is trading sideways in a narrow range of 240-253.  A break through the top of the trading range would be bullish with a target of 279. iShares Dow Jones US Healthcare ETF (NYSEArca: IYH) would be the way to play the sector should it gain momentum and break out of the three-week consolidation.

Last week, I noted concerns about homebuilders, real estate, financials, and energy. Each was showing signs of topping, but managed to rally back near their short-term highs. They are still not showing great strength.

The evidence shows that optimism is picking up. But earnings could be the reality test for this rally’s move. The short-term risk is high as a result of the four-week move to the upside without a test. Some technical indicators point towards an overbought market. Bad earnings or economic news could put the kibosh on the current rally. Again, managing risk in the current market is critical. 

Jim Farrish, founder and editor of Melbourne, Florida-based SectorExchange.com, writes regularly about sectors and speaks widely about investing and money management.

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