Quite a rally, can it last?

Commentary: The general markets made their second trip down to test their rising 20-day moving averages in less than a month, even after tagging new recovery highs earlier this week. The Federal Reserve issued their policy statement on Wednesday afternoon, as is common; there was plenty of volatility surrounding the announcement that afternoon and through the end of the week. While the markets continue to trend higher overall, the big question facing traders is whether the markets are ready to begin a much deeper correction to the rally that began in March. Without a doubt, the bulls have had the upper hand over the past several weeks, and at this juncture, the benefit of the doubt remains with this simply being a pullback to relieve overbought conditions. However, there are cracks that continue so appear on the charts, and alert traders should be cautious moving forward.

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In looking at the chart for the S&P500 as represented by the S&P 500 SPDRS (NYSE:SPY) ETF, you can see a few signs pointing at possible warning signs that some distribution is setting in. If you look at the volume, notice that the higher volume days are dominated by selling. This means, that the days with the most activity have been days where it is likely that institutions were distributing their holdings. SPY is also showing a MACD divergence which hints at waning momentum. This typically occurs as a rally gets extended, and while not a guarantee that a top is forming, it is a good warning signal that caution is in order.

The Diamonds Trust, Series 1 (NYSE:DIA) ETF which tracks the Dow Jones Industrial Average also shows a similar pattern. Both ETF’s pulled back to their prior breakout areas, and slowed down near their rising 20-day moving averages. With the high volume distribution days and negative divergences as a warning, it appears that these ETFs will soon be pulling back a little further to test these levels as support. If buyers step in, then it will mark this area as possible support and signal a probable retest of the recent highs. A failure would probably signal a test of the September low and rising 50-day moving average.

The iShares Russell 2000 Index (NYSE:IWM) ETF has held up a little better than its large cap peers, although only by a marginal amount. IWM began a pullback towards the September breakout area, but has yet to reach this area even with some fairly persistent selling this week. It is also showing similar cracks in its armor, such as the high volume distribution days and negative divergences. These are only warnings at this point, and much will depend on how IWM deals with support in the coming few days.

The Powershares QQQ ETF (Nasdaq:QQQQ) has another ETF that has outperformed SPY and DIA. Much like IWM, QQQQ has yet to reach the prior breakout area and rising 20-day moving average. This also happened despite the sharp selling seen on Wednesday and Thursday, and also with the huge drop by Research in Motion Limited (Nasdaq:RIMM) on Friday. The $41 area is a level to watch for possible support, which could be a decent area for buyers to step in.

Bottom Line
Last week we mentioned that it was possible that the markets would begin digesting some of the recent rally, and at this point, this is what is occurring. The next week will be important to see how the market indexes deal with support levels and whether buyers will continue to buy the dips. There are definitely some weak spots in the charts, but price action remains in an overall uptrend. Traders should remain patient, yet cautious at these levels, as the longer term patterns are in flux with near term action. Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!