In my July 3 article I warned that the market was oversold, dangerous, and vulnerable to a crash. On Tuesday of this week, the S&P 500 opened down, breaking significant support, and kept moving lower. I thought to myself, "This is it. Crash in progress." Then subtle buying began, the decline was stopped in its tracks, and an advance began that lasted three days. My sense of the events was that the Crash Prevention Team had acted, but that is pure speculation about an urban myth. Certainly there were fundamental events later in the week that assisted the rally -- the president's lifting the executive prohibition of off-shore drilling, and oil prices dropping to $130 -- but the price reversal during the first hour on Tuesday seemed magical to say the least.
At this point the advance has hit the overhead resistance of a declining tops line. If that is decisively penetrated, I would conclude that the rally will continue, although, there is another declining tops line dead ahead.
While the volume for the rally has been convincing, and medium-term indicators are very oversold, I am not so impressed with two key short-term indicators shown on the next chart. The Climactic Volume Indicator (CVI) and the UP Participation Index (PI) are where I look for evidence of an initiation climax, which would confirm that an advance is receiving broad participation from both volume and price. (An initiation climax demonstrates that the initial surge of the rally has sufficient internal strength to support and extend an apparent price reversal.) So far the CVI and PI levels are far short of the overbought levels needed to reflect that an initiation climax has occurred; although, this deficiency could be remedied next week. At any rate, I recommend keeping an eye on these indicators as (if) the rally continues.
Bottom Line: A crash was averted this week, and the potential for a new medium-term rally has developed. There are plenty of reasons to believe in this rally, but be advised that important short-term evidence has not yet materialized. If prices head back down for a retest, the danger meter will be redlined. If the rally does indeed continue, there will be wide-spread belief that the bear market is over. In my opinion, that conclusion will eventually be proved wrong. Participation in the rally, if it develops, should be managed on a short-term basis and on the assumption that it is only a bear market rally.
