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Last week, major US equity averages like the Dow and the SPX rallied to new all-time highs on the news that the Fed is delaying the taper. On Thursday and Friday, the markets pulled back but remain above the upside breakout level. This looks like a classic case of a breakout and pullback to me.

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Traders have to allow for the possibility that the market may pull back further below the breakout level as a test for the bulls. Analysis from Ryan Detrick of Schaeffers Research indicated that the coming week is one of the most seasonally weak of the year:

After one of the best starts in 40 years on the normally 'scary' month of September, I showed earlier this week why the rally could continue for the rest of the month.

Well, maybe it isn't quite that simple. Turns out, next week is one of the most bearish weeks historically. We looked at how September does the week after option expiration - so next week. We've noticed over time, the SPX tends to sell-off some after option expiration, but September seems to really drop.

Going back to 2000, the SPX is down -1.12% on average and up just 23% of the time. Compare that with about flat and up 54% for the average week. The median return is actually worse, down -1.63%.

Bulls still in control
Nevertheless, my view is that the bulls still have the upper hand. As I pointed out last week (see Cyclical strength = Taper), cyclical stocks remain in a relative uptrend and the Morgan Stanley Cyclical Index (CYC) staged a decisive relative upside breakout in early September. The CYC/SPX ratio initially broke out in August, but pulled back below relative resistance before surging upward.

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If stocks were to show weakness in the coming week, I would not be surprised to see the same pattern repeat itself.

As well, Street estimates of forward 12 month earnings continue to rise across the board for large, mid and small cap stocks. In addition, emerging market currencies have rallied, indicating stabilization and the lessening of tail-risk of an emerging market crisis in the near future. When the Fed indicated "no taper", it was just a case of pouring gasoline on the bullish fire.

How worried should you be about the debt-ceiling debate?
The real test of market psychology is whether the stock market will get serious jitters over the prospect of a government shutdown or possible default. I agree with Yves Smith when she wrote that this is the same-old-same-old kind of political grandstanding we've seen in the past:

So hang tight for way too much unnecessary melodrama over the next month. It's another round of watching the two parties play chicken, with each posturing that it won't be the one to steer out of the impending crash. The fact is that Obama really wants his Grand Bargain. All of this high drama is necessary for him to pretend to his base that he was forced to do what he's been trying to do for years: sacrifice old people since he perversely believes that "reforming" Social Security and Medicare will get him brownie points in the presidential legacy ledger. This staged impasse is hard to take it as seriously until there's evidence that this iteration of budget farce really is different from its predecessors.

For now, I remain cautiously bullish. One of the key barometers of how the market feels about the prospect that the budget-ceiling fight would seriously hurt the government is the performance of defense stocks. The chart below of an Aerospace and Defense ETF (ITA) against the market (SPY) shows ITA in a major relative uptrend. While it had pulled back somewhat last week, it was a pause from a highly overbought level.

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Looking beyond the week, the weekly chart below of the NYSE Summation Index, which is a measure of market breadth, has turned up. I imposed a slow stochastic on the Summation Index in the top panel and showed the SPX in the bottom panel. The slow stochastic shows that the Summation Index is not overbought and, if history is any guide, market strength should continue for at least three weeks.

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So relax. The market may show some minor weakness in the week. Unless the fundamentals seriously deteriorate, such as forward earnings start to fall, the bulls are still in control of the tape.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Source: Breakout And Pullback?