Climbing a Wall of Worry

03/01/2010 11:09 am EST

Focus: MARKETS

Dan Sullivan

Editor, The Chartist

Dan Sullivan, editor of The Chartist, says pessimism is priming the stock market for a further rally, but first the market will have to break through resistance.

Few investors recognize the initial thrust of a new bull market. Even if they are fortunate enough to establish positions early enough, they are frightened out on subsequent pullbacks.

Only a few weeks ago, investors who were left at the post were prepared to take positions once stocks pulled back to what they considered more realistic levels. Now that the market has accommodated them, they remain reluctant.

Having been burned so often during the bear market, it becomes increasingly difficult for investors to step in during the early phases of a bull market. The rapid appreciation in stocks is watched with total disbelief.

Neophyte investors refuse to buy because bull markets usually get under way during recessionary periods. The more astute realize that the greatest rallies come from the depths of these recessions and are well under way by the time the recession has bottomed out. Neophytes will be doomed to failure as long as they continue to base their market activity on what is written in the newspapers and financial press.

Thus far, there have been three distinct pullbacks in this bull market, but the most recent that began on January 19th and ended on February 8th was the most unsettling to overall sentiment. Over that time, encompassing 14 trading sessions, the benchmark Standard & Poor’s 500 index lost 8.3%.

The pullback took its toll on bullish sentiment, which, according to Investors Intelligence, dropped from 52.2% on January 19th to 34.1% on February 9th. During the prior pullback, bullish sentiment did not waiver all that much.

So, what shook up the bulls this time around? Probably the suddenness of the correction. After recording bull market highs on January 19th, the Dow Jones Industrial Average lost 122, 213, and 216 points over the next three trading sessions, respectively. From that point, the angle of descent slowed, there was a meager rally and then more selling.

This sudden shift in sentiment set the stage for a sharp rally, but whether the corrective activity has run its course remains to be seen. The rally on February 16th was most impressive, with the Dow jumping 169 points. Upside volume exceeded downside volume by a ratio of 9.9 to 1.

With the market in a heavily oversold condition, a powerful snapback rally was certainly overdue; however, a great deal of technical damage has been done, and while we feel that the bull market will prevail, it is going to take a while to be repaired.

The S&P 500 and Dow are now bumping up against overhead resistance. It will be recalled that prior to making a break out in late December, both of these key indices had been locked in a fairly narrow trading range for several weeks. This range now represents overhead resistance.

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