Stocks Struggle to Build a Bottom

06/08/2010 1:00 pm EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, says some indexes have broken through support levels, but the level of fear suggests a market bottom may be forming.

At my Las Vegas Money Show presentation earlier this month, I focused on two moving averages I was keying on as indicators of the market’s health in the wake of the flash crash decline and its aftershocks:

1. The Standard & Poor’s 500 index’s 160-month moving average.  This long-term series was very significant as support at the 2002-2003 lows, and once it was broken in October 2008, a downside cascade ensued. I indicated that it would be a big plus for the market if this level could be retaken by the last trading day of May, but [that didn’t happen. It ended the month at 1,089,] while the 160-month is at 1,167.

2. The S&P’s 200-day moving average. Unlike the 160-month, a glacially “slow” moving average that is essentially a creature of the technical analysis toolbox at Schaeffer’s, the 200-day moving average is very widely followed. The S&P’s 200-day is [above Monday’s close of 1,103].

This all said, I consider the health of the Russell 2000 Index (RUT) to be of even greater importance, because the strength of the rally off the March 2009 bottom has been very much concentrated in smaller-cap stocks. And a breakdown in the leadership area of the market is likely to have heightened negative implications.

[Since the] March 2009 rally, all pullbacks in the RUT have thus far been contained at the 80-day [moving average], and any downside penetrations have been brief in time and/or shallow in price. The RUT [closed Monday at 618.49, well below] its 80-day moving average.

The RUT’s 160-day moving average contained the February 2010 pullback and has thus far contained the May pullback; the “flash crash” plunge on May 6th bottomed just three points above the 160-day. It would be very encouraging to see a quick move back above this level as a confirmation of an ongoing up trend that was interrupted but is still intact.

An exchange traded fund (ETF) of great interest is that of the iShares Lehman 20+ Year Treasury Bond (NYSEArca: TLT), a measure of US government bond performance.

Note the recent spikes by TLT to the extremely important $100 level, and the subsequent severe rejections at that level. Bonds and stocks have been moving in inverse fashion for quite some time now, with bonds being considered the “safe assets” to which investors flock when they’re fearful.

Along these lines, TLT’s trading volume on several occasions this month comfortably [exceeded] volume during the 2008-2009 price spike related to the financial crisis and stock market panic.

This huge TLT volume spike strongly suggests a level of fear among investors disproportionate to the relatively minor extent of the stock market pullback, which would suggest to me and other contrarians that a stock market bottom may well have been put into place this month.

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