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September 2, 2006 NASDAQ, S&P and DJIA Outlook

First, the VXN is well into the lower end of its range...and finding support at the lower Bollinger band. It has yet to actually spring up and off that band line, but it will - eventually. Each day the VXN sinks and the NASDAQ rises, the spring-loaded trap gets wound even more tightly. Which brings us to the second pitfall - we're well into overbought (stochastic) territory.

Third - and perhaps the biggest red flag - is the distinct lack of volume behind all of this buying. The recent gains have only had minimal volume behind them. Even more telling is the fact that last week's only bearish day was also the highest volume day. Fir the rally to be sustained, the volume scenario should be the other way around.

OK, so when, and by how much? The bigger picture trend is a bullish one...maybe too bullish. We need to make some sort of correction soon, primarily to unwind the overbought problem. Realistically, a slide back to the 20 day line at 2141, or even the 50 day line at 2108 would be more than enough to take care of that. The thing is, we may need to go even just a tad higher to spark the dip. The most likely beginning of any selloff, if we do indeed go higher in the coming week, is going to be the 200 day line. Be sure to watch closely what happens if we get there.

And by the way, if we work past the 200 day line without any glitches, it may be enough for investors to shrug off all these obvious risks and further accelerate the rally. We'll look at that when and if the time comes.

NASDAQ Chart

S&P 500 Commentary

The S&P 500 rallied to 1311.0 on Friday, picking up 7.20 points (+0.55%), which ended up being the best day of the week. And speaking of the week, the large-cap index only gained 1.23% over the previous Friday, by adding 15.90 points over the last five days. The superficial math looks fairly bullish, but you may want to check under the hood. (continued below)

That, however, doesn't change the fundamental problem - the VIX is still showing way too much complacency overall. VIX readings at or under 12 (like they are now) are associated with market tops. We don't think this one will be any different. The question is just one of when. We expected to see any correction by now, but so far, it hasn't happened. We still expect to see it. But, we no longer think it's going to be a major one. The S&P 500 is up by 6.0% over the last six weeks, so the bigger trend is undeniably bullish. As for any dip, the combined 100 day and 200 day lines at 1277 should be the worst case scenario. That would allow the VIX to bleed off most of it excess confidence, and relieve some (if not all) of the market's overbought pressure. However, it still doesn't answer 'when'. It should be soon, but we may need to retest the 2006 high of 1326 before we start such a selling spree. Or, a couple of closes under the 10 day line at 1300 would be the alternative sell signal.

In either case, the pullback should be trade-worthy. And, when and if we gat past 1326, we think the bullish rally will also be a big one. Anything between 1295 and 1325 is something of a no-man's land.

S&P 500 Chart

Dow Jones Industrial Average Commentary

The Dow Jones Industrial Average actually led Friday's charge with a 0.73% gain, adding on 83 more points to close out at 11,464. On a weekly basis, however, this blue-chip index only gained 1.6%, or 180 points. On a relative basis, the Dow still appears to be the safest place to be for long-term investors, but we also still see a short-term bearish trade in the works here...meaning we're due for at least a small dip within the bigger bullish picture.

Like the NASDAQ, the gains here are nice, but suspiciously lack volume. Plus, the momentum is waning now that we're back into overbought territory.

The Dow's bigger make-or-break level is this year's high of 11,709, but that's not quite on our plate just yet.

Dow Jones Industrial Average Chart

Have a great week!
Price Headley, CFA, CMT - President & Chief Analyst
James Brumley - Research Analyst