5 Reasons This Rally is for Real (And 2 Potential Roadblocks)

by Darrin Donnelly on September 7, 2010

Click chart to enlarge.

Click chart to enlarge.

On Wednesday last week, the NASDAQ notched an impressive follow-through day, signaling a new market rally was here.

As with all follow-through sessions, a trader has to exercise caution when approaching reentry into the market. 

A follow-through day OFTEN signals a major shift from bearish to bullish in the market’s trend, but a follow-through doesn’t ALWAYS lead to a new uptrend. 

Follow-through days can and do fail.

Having said that, I offer five reasons why I think this rally is for real.

1. All the major indexes closed the week strong, finishing well above the Wednesday close and at highs for the week. 

Often times, a follow-through session will be followed by a pullback that undercuts the follow-through and thus ends any prospects of a rally. 

I was worried about this happening last week due to the strength of the follow-through day itself (a huge gap-up session).  Instead, the indexes zoomed higher and never showed any signs of a pullback. 

Closing at the weekly high is another good sign of market strength.

2. The indexes broke through their 50-day lines.

Another cause for caution last week was that the follow through occurred just below the 50-day moving average line.  Often times, this can be a key resistance level that knocks the market right back down. 

This didn’t happen and all three indexes jumped right through the 50-day lines without hesitation.

3. Market sentiment is extremely bearish right now.

Contrary to popular opinion, the popular opinion is usually wrong. 

Historically, when investment advisors, as a whole, become excessively bearish, the market is usually on the verge of a BULLISH uptrend. 

As of last week, bearish forecasts, as tracked by Investors Intelligence, were at the highest level of the year (37.7% bearish to just 29.4% bullish).

4. True Darvas stocks are leading this rally.

Sometimes, market rallies occur on the strength of defensive plays or “junk off the bottom.”  That is, stocks don’t rise because prospects look necessarily good for companies, but more so because investors decide that things can’t possibly get any worse for companies.  These “junk off the bottom” stocks powered the 2009 rebound.

Darvas stocks, on the other hand, are the highest earners in the hottest growth industries.  When these stocks start breaking into new highs (or approaching such key pivot points), it’s a very good sign for the markets as a whole.

5. The mid-term election cycle is now in play.

The “Election Year Cycle” is a very real stock market phenomenon. 

Specifically, the stock market has a strong historical tendency to take off just before mid-term elections and end the year strong.  This surge is followed by a continuing bull market in Year 3 of the election cycle. 

These historical trends aren’t bulletproof, of course, but when they do play out, the market usually bottoms in the summer prior to mid-term elections. 

That means, if we’re following the typical election year cycle in this stock market, we should have just bottomed out.

* * *

Now for the flipside…

As Darvas traders, we’re trend followers.  We’re not in the business of trying to predict the stock market.  Instead, our goal is to accurately read the current market and ride the trend correctly.

With this in mind, I offer the two major concerns I have for this market’s rally potential. 

1. Where’s the volume?

Volume was very low last week.  After the follow-through day, when volume increased on the NASDAQ, all three major indexes saw volume decrease to close out the week.  In fact, weekly volume was actually down across the board compared to the prior week.

Light volume is common both during the summer months and heading into a holiday weekend, which perhaps explains the light trade at the end of last week. 

Still, we’d like to see stronger volume igniting a new rally and this is something to keep an eye on.

2. The 200-day line can be troublesome.

The other major roadblock I see for this rally’s potential is the 200-day moving average line.  The indexes often struggle to overtake this line.

As you can see in the S&P 500 chart that accompanies this article, the market has reversed on us the last three times we’ve tried to overtake the 200-day line. 

The Dow Jones Industrial Average closed Friday right at the 200-day line and the NASDAQ and S&P 500 are approaching it rapidly. 

Pay close attention to this pivotal line in the days and weeks ahead.

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