Extended Market Vulnerable to Pullback

The Usual Suspects? — After a week of heavy churning, the markets finally gave up their attempts to break out. We mentioned last week that we would be watching four aspects of market internals. Two factors – Sector Leadership and Market Breadth – have turned decidedly negative. Sentiment has moved off its most optimistic levels, which is ultimately healthy for the markets. As the nearby chart shows, Trendline Support remains the key positive for the major indices.

Friday’s sell off, and this morning’s weakness, are more due to technical conditions than a reaction to the issues which have been visibly playing out in the media recently. You may be thinking, “What of the Mutual Fund Scandal, the terrorist threats, the deteriorating Iraq situation, the mixed economic reports?” Perhaps the markets have gotten ahead of themselves (as they are wont to do), but many of the usual suspects are already factored into the markets:

1) Mutual Fund Scandal: remains a non-issue. Fund flows are strong as cash continues to move into equity funds overall. While some rotation away from scandal-ridden firms – Strong, Alliance and Putnam – is inevitable, it has not damaged the present appetites for stocks. Thus, money is rotates to “clean” outfits – like Fidelity and Vanguard.

2) Terrorist Threats: The markets have mostly ignored Al-Qaida threats, bombings in Saudi Arabia, Italy and Turkey. Recent reports threatening Japan for cooperating with the U.S., and another promising 100,000 U.S. casualties are causing mild apprehension. Sunday evening’s 60 Minutes detailed the chemical industry infrastructure vulnerability in the U.S. may also be adding to the angst levels.

3) Sentiment: Has moved off their extremes. Less complacency is healthy. The modest breakdown in the A/D line is causing some worry, which may alleviate the excessive optimism we saw mid-Summer – a net positive.

4) Iraq War: The war continues apace in Iraq. As Defense Secretary Rumsfield has privately noted, this will be a “long hard slog.” But none of the recent incidents have been materially different from the Summer, when the number of attacks on U.S. soldiers started increasing dramatically.

Look for the support at 1025-30 on the S&P500, Nasdaq ~1850-75, and about 9550-75 on the Dow Industrials. As the markets approach these downside targets, expect investors to resume their dip buying ways. The caveat is that a big break of support would present severe difficulties for the indices; Use those levels as stop loss points.

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