July 20th

Market Commentary:

If it weren’t for options expiration today, this flat trading could be considered bullish after so much buying this week, whether it was short covering or not.

But with options expiration as part of the equation this weekend, we may have to wait until next week to see if there are any real fireworks on the heels of this weeks impressive reversal out of a 2 ½ month confirmed bearish pattern.

Conditions are ripe for a pull back, but with the strength of buying that we saw this week, there may be too much forward momentum to see very much consolidation next week, especially if trading remains as calm as what today brought.

On a normal short covering spike rally, which I still believe much of this week’s gains were, the indexes will retreat back to the gap of the spike rally. But with the injured bears on vacation now, prices could consolidate in a mostly sideways pattern, setting up another advance after a few days of pause.

On the other hand, significant resistance is very close overhead, i.e., at the June highs, where this March rally appeared to peter out. For the S&P that resistance level is 956. The S&P 500 closed at 940 today on mostly sideways trading following the impressive spike rally.

All kinds of short-term indicators suggest that the market is at extreme overbought conditions. When combined with strong overhead resistance only a few points away the setup is almost perfect for a retreat now. Almost as perfect as the bearish head and shoulders pattern that existed when this week began.

The odds on a confirmed bearish head and shoulders pattern predicting that S&P 500 prices would decline to the low eight hundreds were very high. Everyone knew it – and that may have been part of the problem.

When too many line up on one side of a bet, the winner can often be found on the opposite side – especially when they are big boys who control at least 50% of all NYSE trading. I suspect the chance to beat the bet and help the Fed at the same time was just too delicious for Goldman and crew.

And with a whole lot of technical analysts now lined up to bet that the June resistance will hold, a similar wager could be easy for these big market movers to chew on.

The DOW chart below illustrates the resistance dilemma the bulls face and the bears cling to:

You can see that the DOW closed at 8744, just under resistance at the 200-day EMA (green line, 8763) and nearing the June high at 8878. These are two valuable barriers that the bulls want in their grasp. They are often formidable measures, though, and I am sure the bears are just as encouraged by that fact.

This leaves traders in that gray area we call “doubt”. Doubt about whether the bulls can really push much higher without a correction. Doubt about whether prices will consolidate sideways or downward. Doubt about whether resistance can actually turn the market back down now. Doubts about which side of the fence one ought to be on.

When in doubt … (you know the rest).

If the markets are able to power above these resistance levels and hold them then there will be a very large bullish head and shoulders pattern that could easily be confirmed with a little more buying, one that would mostly erase the bear market and get prices back to 2007 levels if it completely plays out.

But … as we learned this week, these usually reliable head and shoulders patterns are not always so reliable. Check out the chart, anyway:

This kind of a rally would have the media claim that the bears have been shot and stuffed by taxidermists and put in the cooler for future generations to look at.

But closely look at the potential advance. While impressive it would be, it would be a traditional 61.8 Fibonacci retracement from the bull market highs seen in late 2007 – and likely be followed by a contraction.

This advance would undoubtedly require undeniable success in the government’s stimulus spending, with measureable job recovery, improved retail spending, and a rebound in the housing market – all big deals. At least I think it should require this kind of economic consensus.

With the chances for a second huge stimulus plan growing, the probability of a government health care system close at hand, and lots of higher taxes in the coming years to pay for this largesse, it becomes difficult to reconcile a new bull market with an underlying economic base that is so fractured and weak.

In spite of the huge disconnect, one cannot argue against the bulls this week. They won this week’s battle handily.

Trust me though, the fight will go on.