By Bruce Zaro

Last Friday's ugly sell-off makes many wonder if the New Year’s rally has already run its course. Just as it got started, earnings season had to arrive.

While I believe earnings gains will come through again at double-digit levels, the best earnings gainers will likely be the small and mid-size companies. Although a case can be made for better valuations existing among large-cap issues, such companies are less likely to post blowout numbers and more apt to count as disappointments, with Citicorp and GE standing as two prime examples from last week.

As the earnings season was kicked off, the market indices were losing a bit of upside momentum in the very short term. That rally during the first week of ‘06 left stocks largely residing at the extreme top of their trading bands: the Dow on January 11th was at 11,011 while the mid point of its expected trading band, a measure comparing a stock or an index to its own historical volatility over a period of time, was 10,523. Likewise, the NASDAQ was at 2,320 while its mid point was 2,115. Each was nearly 100% overbought in the near-term, leaving a sharp pullback possible.

While I recently wrote that the Dow’s breakout above 11,000 was a positive development, a day like Friday raises doubts and certainly causes one to reassess his own outlook. Surprisingly, a closer inspection on a Point and Figure basis, the branch of technical analysis I value most, showed that last week’s plunge caused little damage to the broad market. In fact, looking beyond the headlines, there were only 6 double-bottom sell signals (where a stock declines below a recent low) on the NYSE and just 13 on the NASDAQ, hardly a broad massacre. In fact, I would not recommend becoming more cautious unless many more stocks were to give such point and figure sell signals. Recent leaders merely tended to trade from the upper end of their trading bands to the middle while weaker performers tended to trade from the middle to the lower parts of theirs. Further deterioration can’t be ruled out, of course, but in the end, Friday’s rout amounted to a pause, not a signal of impending doom.

Now, a word of caution: with 67% of NYSE and 54% of NASDAQ issues on point and figure Buy signals— a slow-moving gauge with a “normal” range between 30% (oversold) and 70% (overbought)— a lot of the money that wants to be in this market is already in. However, while continued deterioration from these levels would be worrisome, I’d call the overall market “elevated” but not yet “overbought” (such are the mystical parsings of a market technician!). Maybe the market does have a bit further to run, then, which would also fit quite neatly with the calendar and its seasonally favorable months of November through April.

In conclusion, Friday’s action merely brought the market to a more “normal” technical position. Market indices are now nearing the midpoints in their trading bands and we are watching the 2nd recent occurrence of markets working off overbought conditions (the prior occasion I wrote about after the market bottomed in October). For now, then, investors can continue to favor this market to the long side.