How long will the New Year market rally last?

Markets have begun 2007 in fine form, but how long can the New Year rally last? Find out what the outlook is for the major indexes, and where to look out for buying opportunities.

A question that just about everyone in the financial world is asking - but nobody has the answer to is: 'How much longer do you think this 2007 market rally will last?' I'm betting you've either asked it yourself... had people ask you... or heard the folks in the financial media asking it ad nauseum... To get to the facts, I simply turn to historical data and what my charts show me.

Right now, we're in the midst of what is traditionally the best six months of the year for stocks. Moreover, my charts tell me that, against all the odds and logic, this rally isn't over yet. The indexes should go higher still over the intermediate to long-term.

Let's take a look at the evidence to see what market forces are at work here, and where the indexes are headed next...

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New Year market rally: shades of 2006

This time last year, the market was painting a similar picture. A New Year market rally lasted through the 'best six months' of the year (November-May), culminating in a May 2006 peak. A brutal selloff then ensued as the 'worst six months' of the year started.

Since then, however, the bulls have blasted their way through the typical summertime market rally, and then ignored the traditional October-November selloff (particularly during mid-term election years like 2006, and despite a wholesale change in Congressional leadership).

And when the Dow made new all-time highs in October, with all three of the major small-cap indexes (Russell 2000, S&P 400, and S&P 600) following suit in November, that's when it was apparent that the markets were ignoring the normal cycles and were set for a sustained rally.

But what's driving this market rally? In a word: Liquidity.

Stock markets rally while commodity hedge funds liquidate

Just as the stock market was enjoying its end-of-year surge, the commodities market slumped. And there was so much money in the hands of hedge-fund managers, because of liquidation in the commodity markets, that money had to filter somewhere.

So in addition to the growing number of private-equity funds and the redeployment of funds by real-estate speculators, the money found a home in the stock market.

Yet all this happened amid pretty poor economic news. The last two quarters have seen U.S. GDP growth slow... the U.S. dollar has suffered a hammering against several major foreign currencies, amid sky-high budget and trade deficits... and geopolitical factors like the war in Iraq continue to worsen and cost ever-increasing amounts of money.

Since July, the biggest correction that the S&P 500 has experienced is a paltry 2%. That can't last forever, and over the shorter-term, we could see a correction begin at any time. When that occurs, it should provide a great buying opportunity. Here's why...

What's in store for the major indices?

Over the past four years, the strongest-performing market indices have been all three of the Dow family (Industrials, Transports, and Utilities), along with the three major small-cap indexes. These are the only major indexes that have traded above the highs set in 2000 - and all have reached record highs recently, except for the Dow Transports.

Of the three major equity indexes (Dow, S&P 500, and Nasdaq), only the Dow has reached a new all-time high. But where are they going from here? Let's take a look...

Dow: By making new record highs last October, we're looking at a longer-term price target around the 13,490 level for the Dow Industrials. However, it needs help from the Dow Transports. I doubt the Dow can attain this level over the near-term, unless the Dow Transports take off and make new highs before a correction sets in.

S&P 500: The SPX is the only index of the three that has not made new recovery highs. It got to within a mere point of doing so on January 12 this year, while the March S&P futures got to within three points of a new recovery high. If the futures trade above 1,444.25, the SPX should get up to its shorter-term projected target around 1,443. If the SPX were to make new all-time highs above 1,553, its long-term target would be in the 1,840 area. However, this isn't likely before a substantial correction occurs.

Nasdaq: Although the Nasdaq indexes both made new recovery highs last week (putting them back 'in sync' on the upside), they're a long way from making new all-time highs. The price action on the Nasdaq 100 daily chart projects a minimum target of around 1,860. This level isn't very far away - and could get there very shortly, as the Nasdaq Composite has already reached its target.

Small-Caps: These indexes are showing bullish chart patterns. They traded above their 2000 highs in 2004, and reached long-term, minimum targets last spring. But the buy signals triggered on their daily charts back in July projects a minimum upside target of 830 for the Russell 2000... 861 for the mid-cap S&P 400... and around 429 for the small-cap S&P 600.

An important stock market indicator to watch

One valuable indicator to watch for is the NDX/SPX spread (the trading gap between the two indexes). It usually leads the way higher when the markets are bullish and lower when markets are bearish. But in this case, it also helped to identify a good buying opportunity in late December 2006.

Take a look at the daily chart of the NDX/SPX spread below. As I noted earlier, the SPX has only corrected about 2% since July. But the NDX pulled back about 5% going into the end of the year. After a strong six-month market rally, you might have expected a bigger subsequent correction than 5%. But the spread tipped me off by correcting exactly 38% (a key Fibonacci retracement level) before reversing higher.

Chart Courtesy of Trade Navigator Software:

2007 stock market rally buying opportunities

So what can we conclude from this technical evidence?

Short-Term: It's no secret that the markets are getting overbought again - and could consolidate or correct at any time. It's long overdue. Since the Nasdaq indexes are close to their shorter-term minimum targets, we can probably expect them to be reached first. Any pullback prior to that is a good, short term, buying opportunity.

Intermediate To Long-Term: If the markets continue to climb and the Nasdaq indexes reach their upside target, we'll then be looking at new recovery highs on the SPX. If that occurs, it's possible for the SPX to reach 1,443 before a serious correction could get underway. Either way, any decent correction prior to the indexes reaching their upside targets is a buying opportunity over the intermediate-term.

By Jim Stanton, Technical Analyst, Mt.Vernon Research for the Smart Options Report,