Ready for the Pause That Refreshes

08/03/2009 1:00 pm EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, chairman and CEO of Schaeffer’s Investment Research and senior editor of the Option Advisor, says stocks may pause if the S&P reaches 1,000.

Friday’s Standard & Poor’s 500 index close at 987.48 brings us to within a chip shot of 1,000, and this “super round number” has several layers of significance.

First, there is the general propensity for markets to gravitate to round-number levels and for such levels to act as significant support and resistance or, at the very least, levels at which prices pause.

During the market slide that began in late 2007, the S&P 500 first closed below 1,000 on October 7, 2008. By October 10th it had traded as low as 837, but on October 14th it had rallied to trade as high as 1,044 before closing at 998 and heading south again. The final unsuccessful retest of 1,000 occurred on November 4th, and this was followed by a sharp decline to 741 in less than three weeks.

But of equal significance to the “round-number factor” is another strong tendency that is as surprisingly persistent as it is simple: Major declines in stocks and in the overall market often terminate at 50% of peak levels, and rallies off the subsequent bottom often terminate at 50% off the lows.

The decline by the S&P off its bubble peak in 2000 at 1,553 ultimately bottomed at 768 (a 50.5% decline) and the subsequent bull run blew by the 50% rally mark and “round tripped” in October 2007 to 1,576. The March 2009 lows at 666 overshot to a 58% decline, which brings us to our current 46% rally off the bottom.

In the likely case that we touch the 1,000 mark in the near future, at the very least I would expect some hesitation in the rally, much as the decline hit a speed bump at that level last October. The key question, of course, is whether this will mark a termination point in what will have proved to be a rally in a bear market or whether the advance will resume.

I feel there are some reasons to be optimistic. The decline into the March bottom resulted in the most oversold extreme in modern times and a subsequent very rare and powerful buy signal based on the 14-month relative strength index of the S&P. This argues for a recovery that is more robust than would otherwise be expected.

In addition, our sentiment indicators reveal a very tepid state of bullishness that is inconsistent with the magnitude of the rally we’ve experienced and [indicates there is money on the sidelines] that could power the market still higher.

Might we therefore expect another “round trip rally” of the 2000-2002-2007 variety? It’s way too early to gauge, but the first significant markers will be the 195-month moving average at 1,027 (which was broken in October 2008 and was followed by an accelerated decline) and the 160-month moving average at 1,142 (which contained the 2002 decline).

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