Let’s take a look at the positive action driving the markets…

Just as I predicted, the broader U.S. stock market continues to surge higher. Take a look at this daily chart of the S&P 500:

The S&P 500 is a good proxy for the broader U.S. stock market. And as you can see, stocks continue to march higher. In fact, from a low of 667 on March 9 to last Thursday’s high of 889, U.S. stocks have shot up a mind-boggling 33%.

But that’s not all. Take a gander at the large arrow on the left of the chart. It marks the summit of the market’s last upside run. Because the market reversed course to the downside that day (Feb. 9) and at that level (875), that peak is called – in technical parlance – a “resistance” level.

The market also failed to penetrate this resistance level just a few trading days earlier, on Jan. 28. All told, that means 875 is a pretty tough point for the market to get above.

That’s why the market’s most recent action is more significant than most investors and traders are thinking: It smashed above key resistance at 875 like a walk in the park. No doubt about it, that shows uncommon technical upside strength.

Here’s the best part: When the market breaks through resistance – especially after failing to do so in previous attempts – that resistance level has an excellent chance of becoming a stopping point when the market decides to turn down again.

In other words, strong resistance – once defeated – becomes solid support for future price action. So when the market pulls back – and it surely will – it’s very likely to not fall too much below 875. And I don’t have to tell you that can be very reassuring.

There’s more good news. Just as I thought, the most recent run continues to be backed by higher average volume. And on the chart, that’s marked by the upward sloping average volume line near the bottom of the pane.

Significant? Certainly. When strong upside runs – especially when they include breaks above strong resistance levels – are powered by increasing average volume, it’s a clear sign that higher prices are attracting more investors and traders. And they’re buying more and more shares to prove it. That means lots of upside pricing pressure in the days and weeks ahead.

But before we start the big celebration, take another look at the chart. Notice that while the market has surged higher, it’s done so with very few significant pullbacks.

In other words, the market’s most recent run since the beginning of March – including a staggering 33% pop in prices – has been practically straight up.

I don’t have to tell you that’s a ton of upside action in a short amount of time. And for someone who’s been around the block a time or two like me, that’s a red flag.

Why? Because like many things in life, markets don’t go straight up for very long. And if they do for a while, it only makes sense that they’re going to pull back and take a breather.

Plus, big run-ups mean some traders are likely sitting on some juicy profits. So when they take some of that money off the table, that selling pressure will cause prices to drop.

Here’s what I’m looking for: Over the course of the next few months, we’ll likely see a significant pullback in the 10-15% range. On the S&P 500, that means a drop of 90 to 134 points.

Now, it probably won’t happen violently and quickly. I think there’s just too much investor optimism for that. But it could easily happen over a few weeks, with downdrafts in the 1-3% range.

Best wishes,
Wayne Burritt

May 6, 2009

Wayne Burritt

Wayne Burritt has spent over 28 years as a financial writer, investment analyst and business developer. A natural teacher with a lot of knowledge to impart, Wayne takes great pride in sharing his expertise on the subject of options and investing with anyone willing to learn. Wayne believes that given the right teaching, anyone can become an expert in options.

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