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Merrill Lynch’s technical team is recommending investors sell into recent strength as they view the medium term risks remaining high.  According to Merrill sentiment levels set the table for a summer rally that should fail heading into the third quarter.  They believe the S&P could rally past 1100:

The equity market reached oversold levels and the technical breakdown brought in the bears. AAII and Investors Intelligence bull-bear readings moved to the bearish side giving a contrarian buy signal. Fast money has exited the market as measured by ETF flows – see below. Short-term indicators are out of oversold readings. While overall volume is low, volume indicators are improving, supporting additional gains in July. Based on an annualized 13-week rate of change, MZM collapsed to the worst reading since the 1980s but has since turned positive also supporting a near-term improvement in the market. But due to the technical breakdown in the market and negative intermediate price momentum (Dark Cross of 50-day moving average below 200-day moving average) we remain cautious. This summer rally could take the S&P 500 up to 1100-1130 or 9%-12% off the July 2 low of 1010. But we still maintain lower lows could be reached in the fall.”

Ultimately they expect a deeper contraction later this fall:

“This is worth a mention again. With an upward bias in July during mid-term election and Decennial “0” years, the potential is for a tactical rally in the S&P 500 ahead of a deeper correction into the fall. Going back to 1930, July’s average returns are 0.31% in mid-term years, 2.10% in “0” years, and 2.83% in the combined mid-term and “0” year pattern. The S&P 500 has already rallied above initial resistance at 1040-1050 and filled the downside gap in the 1071 area. The next level is near 1100 and key resistance remains 1130-1150. A sustained break above 1150 is still required to improve the market outlook.

We have favored a shift out of the more cyclical sectors and financials into the more defensive areas such as staples, health care, telecom, and utilities. Our OBOS relative price model still has these sectors improving and discretionary, industrials, and financials deteriorating. The defensive sectors are not overbought and the cyclicals and financials are not oversold indicating this shift is not a crowded trade and has further to go. Defense is still the name of the game.”

Source: Merrill Lynch

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