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Retracing The Rally

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The rally from the September lows was one of the strongest in recent history. It was predicated upon an improvement in the economy and ultimately corporate earnings. The improvement in the economy appears on track judging by recent economic data such as the upside surprise in fourth-quarter gross domestic product (GDP). Corporate earnings, however, have not been as strong as last fall's rally may have discounted.

Granted, some areas of the market are displaying strong financial performance and a solid outlook for future earnings. The health care providers are probably the best example of solid earnings currently. Companies such as Anthem (NYSE:ATH), Trigon (NYSE:TGH), and Oxford Health (NYSE:OHP) have recently raised expectations in a very big way. Other segments of the economy have not delivered such optimistic outlooks.

The broader information technology space remains one of the weakest in terms of earnings and outlook. Cisco Systems (NASDAQ:CSCO) is a pertinent example of that trend. The networking gorilla recently reported earnings that were on the surface solid, but delivered less than stable guidance. The company withdrew guidance for its immediate future quarters, which was a harsh reminder of the difficulties that remain in the networking space.

The trend of reducing expectations in the information tech space has pressured the Nasdaq-100 (NDX.X) lower in recent weeks. The index, through last Thursday, retraced 50 percent of last fall's rally. In other words, it had given back 50 percent of its gains. The NDX, because of its over weighting of tech shares, has by far been the weakest of the major market averages.

The 50 percent retracement level, as depicted in the chart below, is an important technical level. It was, with the benefit of hindsight, a natural level for the NDX to pause at in its current trend. From here, a continuation of the trend below the 50 percent retracement level would portend further weakness in earnings in the tech space. And weak earnings will continue to pressure stocks.

NDX.X - Daily

By contrast, the S&P 500 (SPX.X) had given back 38.2 percent of its rally through late last week. The 38.2 percent retracement level for the SPX is 1085, a level that has acted as a price magnet in the last week.

The SPX is trading relatively better than the NDX because of its diversity. Indeed, the SPX is being helped by the strength in the aforementioned health care providers, along with other sectors away from technology.

SPX.X - Daily

Retracing, backing and filling of rallies is a natural part of the process. Contrary to pre-2000 beliefs, stocks don't move in a straight line. That retracement is currently underway.

In the current climate, some may suggest that stocks got ahead of fundamentals, hence the need for an adjustment. Just how much do stocks need to adjust? Unfortunately, we won't have that answer until after the fact because the future is unknown. However, through monitoring the retracement brackets and various levels therein, traders can intelligently form opinions about the direction of the economy and market.

It's possible that the NDX needed to retrace 50 percent of last fall's rally before advancing again. It's possible that the SPX needed only to retrace 38.2 percent of its rally. Then again, it's possible that additional retracement is needed.

Eric Utley
Option Investor

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