After the rally, what?

To the surprise of many traders, the bulls were able to shake off Monday’s weakness and send the indexes higher. As you can see from the charts below, prices remained in a fairly narrow range, but were slowly able to creap higher to finish at new rally-highs on Friday; thanks in part to an upbeat earnings annoucement from Alcoa (NYSE:AA).  Given the strength that has been shown in the financial markets since early September, many traders are now worried of a possible top, and while Friday’s close will certainly mark a short-term high, the markets remain in a holding pattern above some interesting support levels.

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The S&P500 as represented by the S&P 500 SPDRS (NYSE:SPY) ETF cleared its base a couple of weeks ago and has held above prior resistance near $113 for virtually the entire time. Despite a few blips, the overall action is constructive as the bulls have given up very little ground since setting a higher high earlier in September. The $112-$113 area is starting to firm up as support and should be an important level to watch moving forward. Despite the overall strength, the possibility does exist for a steeper pullback and the $110.50 level may be another area to watch on weakness. This is approximately where the 50-day moving average is and also a level that has seen much trading volume.

The Diamonds Trust, Series 1 (NYSE:DIA) ETF which tracks the Dow Jones Industrial Average also held above its breakout area and moved back about 110 for the first since May. In the event that the bulls lose their conviction, it is certainly a possibility that DIA will pull back and the primary level to watch would be the breakout area near $107. If DIA continues to trade sideways, then this week’s high would be the clear level to monitor. This was the area where the markets clearly saw sellers, and a move above this level could catch some bears off guard.

Tech stocks as represented by the Powershares QQQ ETF (Nasdaq:QQQQ) were able to bounce back this week. Overall QQQQ has not given up much ground since the start of the rally and it remains above a prior resistance level near $48.75. This would be a level to watch on any short-term weakness, but the more important level to watch would be the $47 level which was cleared in early September.

The small caps as represented by the iShares Russell 2000 Index (NYSE:IWM) finally followed its market peers in setting a higher high this week, as IWM finally got above the $67.50 level, which was proving to be quite stubborn. As you can see from the chart, IWM managed to hold above it and finished the week at a rally high. This level held on a few pullbacks during the week, and will be an important area to monitor next week. A failure to hold this level could end up leading to IWM trading back towards the middle of its base near $64-65.

Bottom Line
Despite some sign of weakness, the markets remain above prior resistance levels and have given up very little ground over the past couple of weeks. The tech stocks are the area showing the most weakness, but this should be expected as this group led the way higher and is the most tired. The next couple of weeks will be very important as a light volume pullback could set the stage for a powerful end-of-year rally. However, October has certainly accounted for some scary market pullbacks in the past, which hasn’t really been an issue yet this month. Traders should monitor the recent breakout areas as any weakness that drives the major index ETFs below these levels would be a clear warning signal. If these levels hold, the benefit of the doubt would continue to lie with the bulls.

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Charts courtesy of stockcharts.com