Since the stock market bottomed out in March, the Nasdaq 100 index has led the way forward, with a 55% rally, with the Dow and S&P 500 not far behind.

As the standout index (based on a percentage retracement off the March lows), the Nasdaq 100 is the most important one to focus on here. The weekly chart below reveals that it’s clawed back around 50% of its losses since late 2007.

Correction Coming

The late 2007 sell-off and subsequent rally looks like a classic 5-wave Elliott Wave Theory move, with the current rally perhaps being the fourth wave of a 5-wave downside move.

If that’s the case, the Nasdaq 100 shouldn’t close much above the trendline before the fifth wave to the downside begins. At this point, with all the indexes still bullish and under buy signals, we’ll have to wait and see how the Nasdaq 100 is acting if it gets close to the trendline, which is currently around the 1,710 area.

In any event, all the indexes are getting overbought and once the rally runs out of steam, which could happen this week, we should see a correction at least. And the way the correction unfolds will give us a better idea of what to expect over the next few months.

So with that in mind, we’ll focus on a relatively weak sector this week that could be shorted once the rally runs out of steam…

Oil Index Hits Its 50-Week Moving Average… And Is Headed Down

If the stock indexes do succumb to the overbought conditions and reverse course sharply, we’ll probably hear that the recession may linger longer than expected.

If that’s the case, crude oil inventories will probably continue to rise, due to lack of demand. That would put pressure on the oil stocks. Take a look at the weekly chart of the AMEX Oil Index (AMEX: XOI).

Having topped out in May 2008, the index went on to give up about 55% of its value just four months later. Since reaching its lows in September, it’s climbed, but has underperformed the stock indexes, as it worked off the oversold conditions. You’ll notice that the latest move up stopped at the 50-week moving average before turning lower last week.

How To Play Oil’s Next Downside Move

While the stock indexes made new recovery highs in early June and then again last week, ^XOI was unable to follow suit. The chart looks to be in a bearish consolidation pattern and if that’s the case, a test or break of the lows is likely once the current rally runs its course.

The top of the consolidation pattern is around the 1,055 area and selling calls or buying puts would be a low-risk trade if it manages to get back up in that vicinity. However, if the stock indexes turn lower before that occurs, barring unforeseen problems in the oil market, it will probably continue to move lower.

In that case, the first support level is in the 845 area and then at 750, which is at the bottom of the consolidation pattern. A close below 750 would probably take it down to its next support level in the 650 area.

The two weakest-looking stocks within the $XOI are Valero Energy (NYSE: ) and Hess Corp (NYSE: ).

Jim Stanton