Ready for the Breakout?

04/21/2008 12:00 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, says we’re on the brink of a market breakout above current resistance levels—but that may not be the start of a new bull.

Market observers of all types are aware that there is a “ceiling” on this market right now, and if the market could only punch through that ceiling, everything would be wonderful again.

It’s not unprecedented, of course, for the market to develop a trading range as it’s attempting to make a bottom. The real question we should be asking is this: If an upside breakout does occur, does it really mean that the bear market is over?

First, let’s review the current situation. It is very obvious that the market rallies that topped out on February 1st and then again later in February, stalled at about the same price. For the Dow Jones Industrial Average, it’s roughly 12,800, and for the Standard & Poor’s 500, it’s 1400. (The Dow closed above that level Friday, but the S&P 500 closed at 1390—Editor.)

This bear market is not over until that resistance level is overcome (or until another bottom is eventually established at much lower prices). But if the resistance is overcome, does that mean the bear market is over?

Not necessarily. The rally in September and October 2007, after the breakout [above 1490], was a strong one (80 points), but it wasn’t an “all clear” sign to jump back into the market—and neither is the current situation, even if an upside breakout does take place.

What bulls are hoping for, though, is a bottom like the summer of 2006 or the bear market bottom that spread out from July 2002 through March 2003. In 2002-3, the process of forming a bottom was volatile and took nearly nine months to complete, [and] the actual breakout didn’t occur until May 2003. The length of that bottoming process was important, though, because it was the foundation for the four-plus-year bull market that followed.

But even if an upside breakout does occur, how do we know if it’s the beginning of a new bull market [rather than just] a tradable rally, as in the fall of 2007? We don’t know, for sure, but we don’t need to know.

All I can say for sure is that if the market currently breaks out over Dow 12800 or S&P 1400, then we want to be long. We’ll use trailing stops and/or a close back below the current resistance level (which would be a support level after an upside breakout) as our stops. Aggressive traders will short the market as it nears resistance, planning to cover if a breakout occurs. That short covering is often the impetus for the breakout to be strong and swift if it ever occurs.

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