The summer is coming to an end for all practical purposes, with many traders returning from their vacations to a budding sharp rally. This presents an interesting situation for traders, for the historically weakest period lies directly ahead – the September/October time frame. Hence, the question is whether last week's rally was counter-trend in nature, or whether it represents a "thrust higher" of another sustained rally towards higher highs. In our opinion, it is too early to determine – but there several critical levels that will provide additional confidence in one viewpoint or the other.

Last week's S&P 500 rally was strong in terms of price and breadth, but not volume. This remains the hallmark of all rallies off the Mach-09 lows. But our main focus is upon the developing bearish consolidation after the sharp April-to-July decline. This ongoing consolidation is now approaching major overhead resistance at the 140-day moving average, which has proven its merit as resistance to the previous two rallies. In each case, this has led to a decline into major support at 1000-to-1038 zone.

Hence, if one is bearish such as we are at this point – the risk-reward dynamic is favorable for selling short the market upon a move upwards of 1116. One's stop loss point would be a breakout above the previous recent high at 1132, at which point it would be rather clear a larger and more powerful will have begun.

Today's message is going to represent a shift in emphasis in favor of stocks. As you know, I've been writing since the spring about the huge move into bonds and out of stocks owing to fears of economic slowdown and deflation. I've also written in the past (June 17 to be exact), however, that a four-year cycle bottom is due sometime during the second half of this year. Although that four-year bottom usually kicks in during October, the last one (2006) took place during July and August (so it can happen earlier). It's also well known that September and October can be especially dangerous months. Having said that, one of the main reasons why I'm now leaning toward the view that this year's four-year bottom may occur sooner is the presence of so many potential "head and shoulder" patterns that are visible on stock charts. The
S&P 500
is an excellent example of one. First a review of what a "head and shoulders" bottom looks like. It consists of three prominent lows (see circles) with the middle low (the head) slightly lower that the two surrounding lows (shoulders). Another feature of the H&S is that the right shoulder (the August low) often finds support at the same level as the left shoulder (May/June low). Another feature is a "neckline" drawn over the two previous highs (formed during June and August). Chart 1 is almost a textbook example of what that bottoming formation looks like. To actually complete a H&S bottom, however, prices need to close above the neckline. That's along ways off. However, it's not soon to consider the possibility that the market may be heading in that direction. Yesterday's explosive rally has already given a short-term buy signal. That can be seen in the point & figure boxes in Chart 2. By combining that possibility that a H&S shoulder is forming with the likelihood for a four-year cycle bottom during the second half of this year, I don't think it's too soon to start reallocating some funds out of bonds (or cash) and back into stocks.

Semiconductors.  Financials.  Small Caps.  10 Year Treasury Yields.

 

Take a look at the following chart as the relative performance of each of the above is plotted against the S&P 500:

 

 These are four of the biggest reasons why the market hasn't been able to sustain a move to the upside since April.  Until relative leadership returns (and stays for more than just a few days), the market is destined to waffle or head lower.

 

Semiconductors have been dreadful.  Talk about a lagging group since April!  The S&P 500 is 3% away from a significant breakout above its June high.  Semiconductors, on the other hand, are currently situated 15% below their June high!  That is NOT what uptrends are made of.  Semiconductors rallied this past week, outperforming the S&P 500 in the process.  That's a great start.  But before you get too excited, please realize that significant price resistance is dead ahead.  In fact, we've included the SOX as our Chart of the Day for Tuesday, September 7th. 
CLICK HERE
to view the critical resistance levels the bulls must negotiate as we enter another trading week.

 

Financials are key to nearly every uptrend in the overall market.  In April, I discussed the lack of follow through within the financial space and that turned out to be a significant red flag as the market topped.  In early August, as the S&P 500 continued testing its 1131 price resistance, the Dow Jones US Financial Index failed to clear 271 resistance.  Once again, it proved to be a warning sign as the S&P 500 dropped nearly 10% over two weeks.  240-271 is a very significant trading range on financials.  Whichever way we break in financials is likely to have a major impact on overall market direction.

 

The Russell 2000 may hold the very first test for the bulls on Tuesday.  Check out this chart:

 

 The downtrend line off the April highs and the short-term price resistance both intersect almost exactly on Friday's close.  Early bullishness next week in small caps could bode well for the overall market.  Those who are in the intermediate-term bearish camp (including Invested Central) could consider trading the juiced ultrashort ETF (TWM), considering the strong reward to risk.  If the Russell 2000 moves much higher, you could exit with minimal loss.  However, if the Russell 2000 has found another intermediate-term high, a juiced short at this level would perform extremely well.

 

The selloff in bonds, and the resulting spike in bond yields, surely played a big part in equities rising last week.  In fact, the yield on the 10 year treasury hit MAJOR support in the prior week and was one of the reasons I felt we'd see a rally last week.  It didn't change the bigger picture, but definitely suggested the bulls had wrestled short-term control and could advance further in the near-term.  I alluded to that in my comments last Sunday evening. 
CLICK HERE
for more details.

 

Below is the chart on the 10 year treasury yield and the key support level just tested:

 

 It appears as though the yield could rise to the 2.88% area to test broken support.  So long as the yield rises, equity prices should remain stable to higher.  If the yield begins falling again, all bets are off.

 

Happy trading!