Confirming evidence of uptrend and excessive optimism

Equity indices continue to make new highs as the uptrend remains intact. Although traditional momentum indicators are overbought, markets can remain overbought for quite a while. A divergence in RSI (lower high while price attained a higher high) is evident in the major indices. This bodes watching as an early sign of a reversal in price trend, however, the timing of such a reversal is suspect (and RSI has been known on occasion to work itself out to ultimately turn consistent with trend).

Investor and money manager polls remain at extreme bullish levels. With many Wall Street projections for the new year exuding double-digit projected gains, caution in joining the ranks of bullish enthusiasm is advised.

The McClellan Oscillator readings turned more bullish last week, as price moved above its 20-day moving average and the Summation Index closes in on a bullish cross (10 points away). This indicator has been a reliable measure of trend. See the chart below:

Although financials have taken on a leadership position vs. SPX, discretionary stocks have weakened at the expense of a bottoming pattern in staples.  The latter indicator may suggest a more cautious stance as equity prices have risen so far so quickly.

Several more positives have surfaced. The relative strength between corporate bonds and Treasuries continues to improve, breaking out of a trading range in place since June (see chart below).

Continued leadership in small caps and growth stocks rounds out the positive signals supporting the uptrend in equities.

Markets reliably pause following a sustained period of gains. SPX is up over 4% in December. With the risk of a trend change or consolidation/correction increasing, our strategy is focusing on capital preservation and protection of gains through tighter stops, covered call sales, with a short hedge for added insurance. This will have the effect of underperforming a strong uptrend (but still generating positive returns), with downside protection.

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Signs of divergence present a caution for Bulls

Several technical warning signs for the bullish case, which began surfacing last week, have continued to fester in the equity markets. These indicators in the past have identified potential turning points in the market trend.  At a minimum, they raise a flag to encourage bullish equity investors to tread cautiously. Here is a review of the warning signs:

Negative divergence with Advances vs. Declines (A/D), as A/D has been falling while the indices (Nasdaq, NYA and others) have been reaching toward new highs.  See the chart below:

Related to Advance/Decline statistics, the NY Stock Exchange McClellan Oscillator has turned negative and its cumulative reading, the Summation Index, is dangerously close to a bear market reading near 400.

Bullish sentiment readings taken in investor polls have been peaking. In addition, VIX has settled back into complacency territory, while Put/Call remains low, both contrary market indicators and settling at levels that ins the past have preceded market turns. See charts below:

VIX:

Put/Call:

You will also notice on the chart below of Nasdaq, that price reached toward new highs while the Relative Strength Index, or RSI, a momentum indicator, declined (note the lower highs).  This relationship is depicted in the black oval in the chart, yet another sign of negative divergence spelling caution.

The growing caution signs for the bullish case at this juncture of the uptrend causes us to hedge longs, take select profits and establish partial short positions. Capital preservation is key at this stage. Often, such divergences correct themselves with some much-needed "backing and filling" of the indices, such as a period of consolidation or trading-range activity, before resumption of the uptrend.

Robert F. Palmerton Jr., CMT - December 16, 2010

Uptrend re-asserts itself

Most indicators have confirmed a bullish bias in the markets, while some indicators flash caution to take some protective measures on long positions.  SPX and Nasdaq work hard to push to new highs. Stocks above their 50-day moving averages have turned around as breadth positively follows the uptrend.  On a short-term basis (next few days?) some concern regarding VIX; its price has gapped below its EMA 50, to raise some concern of a modest pullback.

However, most indicators are decisively bullish.  Here is a list of the positives:

1. Small Caps outpace Large Caps while Growth beats Value. Outperformance by Small Caps and Growth underscores support for equities (small caps have led the way since the 2009 bottom, while growth was also favored during this timeframe, with the exception of Feb-Apr 2010)
2. The Corporate/Treasury Bond relative price has edged upward; a sign of narrower yield spreads and is favorable to equities.
3. Advance/Decline breadth tracks positively with higher equities.
4. A relative strength bounce in financials and continued relative outperformance in the Nasdaq
5. Discretionary stocks continue to outperform Staples
6. A surge in commodities and industrial metals, and a reversal (short-term?) in the US Dollar

Some downsides:

1. Weak to modest volume on the recent rally. This is our largest concern, as lack of volume support could suggest a continuation of the downtrend we saw in early November.
2. A divergence in Dow Theory; Transports have reached to new highs while the Industrials lag.
3. An increasingly complacent VIX and a relatively low Put/Call ratio. 

Sustainable success in trading and investing rests squarely on being on the "right" side of the market, adhering to the trend. When the trend appears to be weakening (we utilize many indicators to tell us when this is happening), potential actions would include taking select profits, setting trailing stops, selling calls, protecting positions with puts or futures, or even adding to positions but in smaller increments. Battling the trend with contrary positions (i.e. shorting a market at its highs), although it may have a winning day with a big move down, is typically a losing proposition. It is better to leave some money on the table and have your profitable longs stopped out, than to see your capital erode fighting against the trend.


Despite the downsides, price action is key and that suggests to stay the course on longs, but to watch carefully for signs of deterioration, divergence, and continued weakness in volume on the upswings. A strategy to sell covered calls may be prudent at this time.

Please visit our charts below on StockCharts.com (if you like our work, please vote at the bottom of the page)!

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Bullish resiliance

Although equities appear to flip direction from one day to the next, internal indicators and sentiment are beginning to put a drag on the uptrend. Whether the current consolidation represents a healthy pullback or something more ominous may be signaled by our McClellan Oscillator indicator.

At this time (prior to Tuesday's close), our reading on NYMO (NYSE McClellan Oscillator) is showing signs of weakness (see chart below). It's close fell below its EMA 20 (whipsawing lately) and the NYSI (a cumulative view of the index) fell below its EMA 20 about 10 days ago.  In addition, NYSI is close to a "bear market" reading (400 and lower) with its Monday close at 466.

On the positive side, major indices continue to sport uptrends. The Put/Call ratio at 1.13 is mildly bullish (in a contrary sense).  Discretionary stocks continue to outperform Staples, and even Finance stocks have seen a bid and some improved relative strength.  Small caps and growth issues continue to lead.

It is interesting to note the relationship between the LQD (Corporate bond ETF) and the Barlays 7-10 Year Teasury Bond, IEF, versus the S&P500.  As the S&P500 has risen since September, the LQD/IEF ratio has remained flat. This ratio tends to lead the S&P500. A flat ratio, however, is not bad for equities. For example, from July 2006-October 2007, this ratio was essentially flat as the SPX rose 14%. A decline in the ratio is worrisome, as it led the SPX by 6 months from July 2007 when it broke support, before the SPX broke support (See chart below).  We will be on the lookout for a decline in this ratio as a bad omen for equities.

As equities consolidate and vary within a trading range, we will look for any volume upticks on an up-day to support adding to long positions, as long as our indicators continue to remain (albeit modestly) on a buy signal.

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Unwinding the froth

Equities took a setback as expected (the challenge was to identify the timing of this setback) as an overbought market and extreme bullish sentiment by several measures took a breather. The percentage of stocks trading over their 50-day moving averages hovered in the 85-95 range (overbought) since early October and was due for a bit of back-peddling.  See chart below:

VIX had also seen recent lows, a sign of complacency, as its gap below its 50-day moving average warned of a decline in equities. This gap has since resolved itself, as noted on the chart below:

Put/Call ratio also leapt rather sharply on Friday, a sign of an extreme rush to caution. This is a bit of a positive (the change in Put/Call on Friday was a 34% increase from the prior day's close), although at 1.03 is not at an extreme (it would take a sharp sell-off and a reading near 1.30 to signal that a short-term bottom may be at hand).

One of our most reliable indicators, the McClellan Oscillator chart on the NYSE, printed a sell signal this week as the indicator fell below its 20-day moving average, and it cumulative cousin, the Summation Index, crossed below its 20-day moving average. The Summation Index had previously flashed a sell signal in late October but quickly reversed itself. Time will tell whether the current signal is valid or represents another whipsaw.  See chart below:

As expected, the dollar saw strength as equities and commodities took a hit on the week. Rates continued to climb as long-term treasuries took a hit (TLT, iShares 20+ Year Treasury Bond ETF,  fell 2.2% on the week).

Caution to longs as this correction sorts itself out. The strength of the uptrend, however, supports continued gains once this overbought condition unwinds further.

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One has to wonder whether there is more risk being long equities versus not being in equities at all, awaiting a pullback. Internal readings of price action underpin strength which has prevented the markets from surrendering even minor gains (on Friday, what looked like a potential down day recovered near the end of the trading session). In retrospect, staying long with some hedges (i.e. SPY puts as insurance) may have been the most prudent action since early September.  Adding to longs during intraday pullbacks is another option (as market participants appear to have been doing), as the potential downside of a minor setback may be worth the risk versus not participating on the long side as equities shoot for potential gains through early 2011. But beware: corrections have a habit of sneaking up on the markets (melt-ups too, as we have seen); November 2007 started strong only to surrender 7% before the start of a strong December. And complacency as noted in our sentiment indicators suggests caution.

Market breadth continues strong, as Advance/Decline ratios remain consistent with the price uptrends. Our McClellan Oscillator and Summation Index metrics reversed course and negated bearish signals printed early last week, as they remain in support of equities, although at extreme overbought levels. 

As for sentiment indicators, VIX and the Put/Call Ratio both flashed red alerts of complacency this week. VIX has fallen well below its 50-day moving average, and the Put/Call ratio, at 0.69, has in the past preceded market pullbacks at this level.

The dollar continues to downtrend, however, the Euro is pushing up against downtrend resistance and, should it fall back from this resistance, may lead to a dollar bounce (and potential clip in equity prices). It is noteworthy that the dollar, although hitting lower lows, has seen positive divergence with a rising RSI. This is an early indicator of a potential trend change in the dollar and a caution signal for long equity enthusiasts:

Gold and commodities continue to surge as the dollar weakens and emerging market growth remains enticing. Bonds settled a bit as long-term rates continued to rise, as optimism in the extended economic outlook rises.

As for stock sectors, there were more positive signs than negative this week. Financials broke out of their doldrums, a positive sign, Nasdaq held rather steady vs. SPX (despite a bit of a lag), and Staples took a hit relative to Discretionaries. As for style, small caps continue to outshine large caps, and growth continues to outpace value.

We expect that a correction in equities will leads to a correction in gold and commodities, and a bounce in the dollar and bonds. Although the near-parabolic rise in equities this week was in part a result of favorable FED and election results, and represented a breakout to new 2010 highs, sometime in this waltz of price action there will be a setback, and investors should be prepared to accept the consequences.

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- Bob Palmerton; November 7, 2010

Waning momentum indicator suggests caution

One of our favorite momentum indicators is the NYSE Summation Index (NYSI), a cumulative indicator based on the McClellan Oscillator, which depicts the momentum of advances versus declines. This indicator crossed below its 20-day exponential moving average on November 1, which in the past has preceded declines in equities. See the chart below:

In fact, momentum has been waning as the market seeks to revisit its April highs. The NYMO itself crossed below its 20-day EMA in mid-October, as market breadth continued to deteriorate.

A firming dollar and strength in staples versus discretionaries, plus continued weakness in financials, continue to weigh on the market.  Small caps have also lagged Large caps as the "risk-on" trade takes a break.

Much rides on events in the news this week, with elections, the Fed and Friday's employment report. If anything, recent lackluster equity indicators suggest caution until these events pass us by.

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Hammering toward the April highs

The age of the uptrend continues to assert itself as equities close well off their highs on Monday, October 25th. Breadth and sentiment indicators continue to point to a decline in momentum while the equity indices struggle to meet their April highs.

The dollar fights to print a bottoming formation (see the bullish reversal hammers that have formed on 10/25 and during the prior week). The consensus accepts the likely outcome of a dollar bounce/rally being accompanied by a decline in equities. Treasuries appear to have settled into a consolidating frame of mind rather than a correction, while corporate bonds have recently caught a bid, both favorable indicators for equities.

On 10/25, the Nasdaq, S&P500 and the Dow all printed inverted hammers (nearly shooting stars), as rallies early-on faded throughout the day. Such days will be necessary to tame the bullishness and relieve the markets of their euphoria a bit prior to making further advances. It is not clear, however, that a correction looms in the near-term, while the trend and our indicators, although overbought, continue to support a bullish stance. This is not the time to enter new long positions, but a time to revisit stops, take selective profits, perhaps sell some calls, and look to the markets for further direction.

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Using trend-following technical analysis techniques, one would continue to desire to follow the trend, trade "what you see" as opposed to trade "what you believe."  However, the "believe" is the challenging word, as we are inclined to believe that the age of this rally in equities is in its final days.

There are more signs of tiredness in this uptrend. We watch the percentage of stocks trading above their 50-day moving averages; both of these indicators for the S&P500 and the Nasdaq have been in the 85-95 range since early October, a range that in the past has preceeded market declines. See the Nasdaq Bullish Percentage chart below. Note that whenever the red Bullish Percentage line is in the 85-90 area, the green equity index line ultimately turns down.

In previous blogs we have noted that VIX has fallen to levels that are risky for equity longs. Once again, VIX has gapped well-below its 50-day moving average, a sign of caution for bulls.  See the blue rectangle in the lower right portion of the chart below:

The Put/Call ratio has also closed at a relatively low .71 (a contrary bearish sign), and Advance/Decline stats have started to weaken (the Nasdaq A/D fell while prices rose on Friday, a negative divergence).

A negative cross of the NYSE McClellan Oscillator, below its 20-day exponential moving average, is further cause for concern. To rub more salt in the wound, Financials took a significant hit versus the S&P500 over the last two trading days. Although we have seen a solid uplift with technology stock outperformance (thanks mostly to Google), we would prefer to see relative strength in Financials also (we had seen a few such signs during the previous week).

So, what we "see" in the markets is a potential trend-change, which may simply be a correction or even a consolidation of recent gains. We plan to tighten stops, take select profits, and hedge with partial short positions just in case the trend change signals prove true.

Click here for the updated Market Tour on StockCharts.com.

Markets continue their ascent with few signals of a potential trend change and an earnest intent to reach for the highs attained in late April.

As for sentiment readings, bullishness continues to sit at heightened extremes (and lows in the case of the US Dollar). VIX has started showing signs of increased complacency, as the gap between price and its 50-day exponential moving average grows larger. This is a cautionary signal and underscores the extended nature of the equity markets.  See chart below:

As for sectors, financials struggle with the broader market, as technology firms and discretionaries lead. Strength in bonds as rates continue to shave basis points appears to be providing support to equities and pressure on the dollar.

As for style, small caps bullishly continue to lead large caps, and growth leads value. Our nightly test of the small to mid-cap stock universe (about 3,000 equities) continues to reveal breakouts and interesting long opportunities, another sign of internal market strength.

The US Dollar appears to have hit a point where Elliott Wave theoreticians are clamoring for a potential trend change. Dollar Bulls rank in the single digit percentages. With the inverse relationship we have seen in the dollar vs. equities, a reversal in the dollar's fortunes could spell trouble for equities. We continue to remain on watch for a trend reversal in equities; it is sure to come and will likely catch us off-guard. Any correction or consolidation we feel would be a buying opportunity assuming our trend forecasting indicators agree.

With US Elections coming up, as well as a G20 meeting in November (which will raise currency debates to a heightened level), we may see current events influence this market more so than economic statistics (a disappointing employment report on 10/8 did nothing to squelch the uptrend in equities). Earnings also loom as reports start trickling in this week (following an upbeat report by Alcoa). The next few weeks can be very interesting!

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Weighing the reward/risk of being long

Most indices continue to look healthy and a recent Dow Theory confirmation (both DOW and Transports reaching new intermediate-term trend highs) add to the positive tone.

However, we are noticing some obvious divergences on the Nasdaq. Upside momentum is slowing considerably as seen by a waning RSI (which crossed below its 14-day exponential moving average).  At the same time, the percentage of Nasdaq stocks trading above their 50-day moving average is close to falling below its 10-day exponential moving average, another indicator we watch to assess price momentum.  See the chart below:

Nasdaq relative strength vs. SPX appears to be correcting from overbought:

We like to see technology lead the markets (we also like to see Financials lead but that has certainly been a struggle).  The loss of Nasdaq momentum could simply be a sign that the index got ahead of itself, and money is gravitating to areas where relative strength has lagged (notice below how energy has picked up this week:

So, the uptrend continues (yes overbought and ripe for a pullback) as money begins to shift into other sectors that have lagged (even Financials saw a modest relative strength pop this week).  Rather than establishing long positions in the major indices, one is cautioned to take a more selective approach and favor those sectors that have lagged the general market and to tighten stops on those sectors that have gotten ahead of themselves.

We would view a correction in the indices (preferrably around 10%) as a buying opportunity, should our trend-forecasting indicator support that view.

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Bullish bias intact with a few wrinkles

Indicators continue to support a bullish bias with a few areas suggesting a slowdown of the upside momentum. SPX and Nasdaq have reached higher highs following breakouts from resistance on modest volume.

An overbought condition has surfaced in the percentage of stocks above their 50-day moving averages. While prices have certainly extended their reach, this indicator in the past has remained overbought for a while before any meaningful market setback.  Notice in the chart below the blue rectangle, whereby SPX stocks over their 50-day remained in the 85%-95% zone through March and April while SPX headed toward its late April high.  This measure just recently hit the 85 level and could suggest continued strength in equities. Note that our indicator also remains above its EMA 20 (blue line), another positive.

Combing through our indicators, we are concerned about the underperformance of financials stocks, as noted in XLF vs. SPX. A less significant concern is the lack of a Dow Theory confirmation, as the Dow moved to a higher high without being joined by the Transports.  M&A activity reported in this sector Monday morning may generate a confirming signal.

Some modest weakness is surfacing in the McClellan Oscillator, which remains below its EMA 20. Also note that the NYSI (New York Stock Exchange Summation Index) has flattened lately, but remains in bullish territory. Action in these indicators suggest some reservation on continued upside, perhaps a slowdown in uptrend momentum.

Overall, we cannot ignore the bullish activity yet the seasonal risk and continued mediocre economic news prepare us to protect our long profits should our indicators suggest a potential trend change.

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Positive trend now faces likely pullback

Although most of our equity indicators remain positive, equities once again are pushing up against resistance, and negative divergence has begun to assert itself, as slowing momentum (weakening RSI on several indices) has emerged. Sentiment, as measured by DSI and Investor's Intelligence, has once again scored peak readings (DSI is at a level last seen at the late April peak in equities).

The probability of a modest correction in equities continues to grow. Bonds may likely experience a bounce during a fall in equities; their uptrend remains intact and their recent correction looks like a healthy decline inviting a favorable reward/risk entry point at this time. The US Dollar has corrected into support and appears poised to resume its uptrend while the Euro looks to follow through on the downside.

On the sector/intermarket front, Nasdaq price relative vs. SPX surged this week (a positive), while Financials seriously underperformed (a negative). Discretionaries continue to outperform staples as the "risk-on" trade persists, while industrial materials (i.e. copper) assert their strength.

Not much has changed since our view from last weekend. A modest unwinding of the bullish optimism we have seen since the start of September will be a welcome entry point to re-establish long positions.

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Positives warrant attention

Despite the weak volume of recent gains, our market indicators have turned increasingly bullish. Be aware that our trend-following methodology simply follows the confirming signals, and tries to identify potential trend-changing alerts (particularly in our sentiment and behavioral finance studies) in order to assess the risk/reward of establishing trend-contrary hedges.

This week, we saw improvement in VIX (flashing a less extreme that would typically foreshadow a trend change to the downside), and a positive ending of the put/call ratio (its close on Friday at 1.28 is a bullish contrary signal, see chart below). When accurate (we find this indiicator accurate about 70% of the time), Put/Call extremes tend to lead equities by 1-2 weeks (potentially foreshadowing further equity gains later this month).

As for sector analysis, Nasdaq has maintained its relative underperformance vs. SPX (a negative), financials have performed "OK," and discretionaries have outpaced staples, a positive sign.

On the intermarket front, rates have edged up slightly (a bullish sign as economic indicators edge upward) and the interest rate spread between corporate debt and Treasuries has narrowed, another positive.

Finally, in the "style" category, small caps maintain a lead vs. large caps, a bullish sign, along with growth stocks taking the lead versus value. See charts below.

So what does this all mean? A growing swell of positive signals (the majority of our charts in our Market Tour on Stockcharts.com are green, or positive), suggests "staying the course" on the long side, with potential resistance marked at the SPX 200-day moving average (1116) and the August high (1128). Potential seasonal weakness in late September and October) looms, however, markets have a tendency to surprise and change character when you least expect it!

Safe trading!


Bob Palmerton

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Market Tour Update

This week's oversold rally on weak volume does not significantly change the intermediate-term outlook, despite positive upside gaps and the formation of short-term lower highs. This short-term trend change shaping up in the major indices should not be taken as a resumption of a confirmed uptrend while prices remain floating between the boundaries of a channel. Note the chart below of SPX. It is encouraging for bulls to see that the July lows were not broken (higher low in August), but a breakout above the upper channel boundary (near 1140) would support favoring the bullish camp.

VIX took an 8% hit to the downside on Friday September 3rd.  With this move, the VIX closing price exhibits an extreme gap below its 50-day moving average, a negative indicator. Such a gap was last seen in early August prior to the 70-point decline in SPX. In most instances, when VIX is about 20% higher or lower than its EMA 50, a short-term market turn tends to occur. See the chart below:

On the plus side, improved relative strength in Financials was a refreshing change this week (see chart below), as RSI of Financials vs. SPX crossed above 50, and the price relative looks about ready to break above its downtrend line.

Staples price relative to Discretionaries also took a hit this week as the "risk-on" trade resurfaced. Small Caps have also taken the lead vs. Large Caps (the opposite of last week), while Growth takes a stronger bid vs. Value.

Equity markets seem to be shifting their character with each passing week (one week bearish, the next week bullish). The weight of the evidence suggests caution as internal breadth and sentiment indicators remain bearish (edging toward neutral) and the intermediate-term trend remains flat. The short-term swing in the trading channel may result in SPX touching the 1120-1130 area, before seasonal weakness and heightened volatility mark the transition from September into October.

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The Day of Reckoning is Getting Closer

Although Friday's bounce in equities relieved some of the oversold bias, the trend remains down and indicators continue to point toward weakness. Today, it seems that "everyone" is a technical analyst, pointing to multiple "head and shoulders" index patterns as well as scary warnings such as the "Hindenburg Omen." With the plethora of fear-raising technicians, one could suspect a continuation of Friday's rally at least into month-end (Tuesday). Waning, directionless trading for the balance of the week as the long weekend emerges feels likely.

Peter Stolcers, who we follow regularly and has significant street experience is looking for a "major market decline that will start this week and continue throughout September."  We consider this a bold call but will not take it lightly as Peter has a great penchant for calling the shots in equities.

Most of our charts in the Market Tour remain the same, despite the bounce and recovery to major support levels. However, we have seen these bounces before, as they appear to be yet another reflex rally during a bear market. Of our many indicators, only VIX saw a modest improvement, as Friday's rally pushed its RSI back below 50 (a modestly-bullish signal). Runner-up is our NYA McClellan Oscillator, which pushed slightly above its EMA 20 (although on the downside, NYA Summation Index has fallen below 400 - a bearish signal -- while a bearish cross below its EMA 20 has ensued).

Should a selloff transpire, we wonder if Financials (XLF) will outperform this time around (beware, they still will fall with the market, just less so).  Looking back at weekly charts over the past 5 years, XLF is showing positive price relative performance in its RSI (higher RSI bottoms as price has fallen), and would be a likely contrary candidate to outperform (as it has so vastly underperformed on price since the April peak).

Treasuries took a big hit as the "risk-off" trade flipped over on Friday. With the crowds beginning to speak of a "bond bubble," once cannot ignore the possibility that a modest correction won't be followed by a continuation in the uptrend in Treasury prices. It appears that the Fed will keep a lid on rates for a while, which may help to sustain the relative strength in this asset class.

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Neutral-bearish perspective

Equities continue to weaken with only subtle signs of an oversold market. However, an encouraging partial recovery toward the market close on Friday 8/20 bodes well for a bounce early next week.

On an intermediate-term basis, several of our trend-following indicators turned negative with this week's decline. Breadth measures remain bearish. Volume on the downside has edged out volume on up-days (even though volume in general is typically muted this time of the year).

Financials continue to show significant relative weakeness vs. SPX.  Partly offset by improving relative strength in the Nasdaq, a rebound in financials is important to drive a resumption of a sustained uptrend in equities. Price relative continues to favor staples over discretionaries, another sign of the "risk-off" trade, as well as the recent weakening of small cap stocks relative to large caps.

Although we may hedge short positions this week, we will view any concerted market uptrend as an opportunity to add to shorts.

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Equities not yet oversold

The red signals as noted in last weekend's post were reinforced today. One of our indicators (also one of John Murphy's favorites) is the relationship between the 13 and 34-day EMA.  Today we saw the 13 cross below the 34-day EMA on SPX and Nasdaq. Volume on today's decline was above its 34-day EMA.

RSI settled near 42 for both composites, suggesting further potential downside before an oversold state is reached.  At that point, as we know, markets can remain oversold for some time and continue to fall.

We are in "capital preservation" mode.

A sea of red signals

Our internal breadth, sentiment, intermarket and momentum indicators flashed a sea of red this week. This is based on our simple tally of RED, GREEN and BLACK (NEUTRAL) readings as highlighted in our Market Tour on StockCharts.com. 

The list of negatives is as follows:

1. VIX breaks above downtrend resistance as RSI moves above 50
2. Put/Call is neutral (showing a sligthly bullish bias at a reading of 1.0)
3. NY McClellan Oscillator remains in a downtrend; having crossed below its EMA 20
4. The Down Volume trend has reversed to the upside, surpassing Up Volume
5. Technology (Nasdaq), and Financials relative strength weakens, while Staples take the lead vs. Discretionaries
6. Recent weakeness in industrial metals and continued signs of deflation based on a lagging CRB
7. A sharp US Dollar bounce (potentially signalling a trend change - the dollar has moved opposite equities).
8. Continued strength in Treasuries (and a recent weakeness in corporate bonds vs. Treasuries).
9. Recent weakeness in small cap vs. large cap stocks (a sign of risk-aversion)

 We will accept these signals and remain on the defensive.

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Market Internals Weaken

Despite the continued uptrend in equities since early July, market internals have weakened as the rally becomes more selective and cautious.

A negative divergence has surfaced in reviewing the advance/decline ratio of NYA and the Nasdaq, as the solid advance in equities has been met with a flattening of the advance/decline ratio. We saw this negative divergence develop while the market rallied from March through the end of April (so this negative divergence can be with us for a while). Also, NYMO (NYSE McClellan Oscillator) has deflected from overbought territory, and it has recently crossed below its EMA 20.

Financials relative strength has weakened against the broader SPX.  Rates have fallen while Treasuries surge, as an aire of risk-aversion returns to the market environment. It is interesting to note that recent CRB strength has deflected from resistance near 280 as RSI corrects from above 70. Small Caps have been consolidating relative to Large Caps, further reinforcing the aversion to risk (and possibly a flight to export-intensive large caps as the dollar weakens).

There is nothing compelling to convince us to take significant long positions as this rally ages. We will tighten stops on longs and take select profits. Edging into counter-trend (short) positions and protecting longs with index puts are favored, as our market perspective remains neutral (with a bias toward negative).

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Weak rally continues.....proceed with caution

Trend following indicators continue to support the uptrend despite the weak volume on the upside. Resistance continues to be the key roadblock (SPX failed twice to beat the 1120 barrier as it closes near 1102).

Contrary signals starting to emerge include the dollar reaching a 50% retracement of its climb from December (and oversold). Considering that the dollar has moved opposite equities, a reversal could spell trouble for stocks. NYMO (NYSE McClellan Oscillator) corrected from an overbought status and is nearing a negative cross of its EMA 20 (a bearish sign).  Put/Call ratio is neutral-bearish, but VIX continues to weaken, a positive sign.

Bonds have been particularly strong as rates begin to weaken (recent weakness in the 3-month T-Bill rate is disconcerting).

Our blend of technical indicators suggest caution and a neutral stance.

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Ride the bounce

Major averages have retaken their 50-day moving averages (Nasdaq has also retaken its 200-day) as market internals improve. The Nasdaq has shows relative strength vs. SPX as the percentage of stocks on Point & Figure buy signals breaks out and the number of stocks trading over their 50-day moving average pushed above bear market resistance.

As for Dow Theory, both the DOW Industrials and DOW Transports have printed higher lows. VIX has settled down and Put/Call remains neutral. We are also seeing higher lows on the Advance/Decline metrics and a high (albeit contrarily bearish peak) in the NYSE McClellan Oscillator. Strength in industrial metals (primarily copper) and a pickup in consumer discretionary stocks vs. staples reinforce the bullish tone.

Skeptics remain, particularly from the camp of the wave theorists. We will respect that skepticism; given the continued weak economic headlines, we will set stops on long positions and hedge with index puts, but will not refrain from adding partial long positions in strong relative strength stocks and ETF's.

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Market Internals, Momentum and Sentiment Update

Combining a review of technical analysis of price with an assessment of internal market strength, momentum and sentiment, can help the market technician arrive at a comprehensive and hopefully accurate perspective on the current market trend, price extremes and potential trend changes.

Let's review the S&P500 (SPX) price activity first, then tour various internal market measures to support our perspective on the US equity markets.

As the chart below displays, the S&P500 (SPX) continues in a trading range bound by 1120 at the upper end and 1060 at the lower end, where it has met support three times since the February lows. Positive divergence is seen in a rising MACD (bottom of chart) and RSI (top of chart) crossing above 50. We like to see price exceed its 34-day exponential moving average (it crossed its EMA 34 today), and prefer that its EMA 13 is above its EMA 34. We have not seen that yet, even through the EMA 13 has developed a positive slope.

Delving deeper into the modestly improving performance of SPX, let's review several indicators of internal market strength.  Two indicators of importance include the percentage of stocks trading above their 50-day moving averages (SPXA50R) and the ratio of Point & Figure buy signals (bullish percentage, or BPSPX).  Are these indicators supporting the mildly bullish perspective of the price chart discussed above?

Reviewing the chart below, it is noteworthy that the SPXA50R has settled into a bear market range, but is struggling to break out.  Notice how the lows during the bull trend (March 09-April 10) fell in the 25-40 range, while the lows during the recent downturn (since the April 26 peak) hovered in the single digits. Highs during a bullish uptrend push toward 95, while highs in a downtrend struggle to beat 50 (see green rectangle and red rectangle). Extremes can be found at these levels, typically preceding a shift in direction in the index (note how SPX-- green line --  bounced when the SPXA50R fell to the single digits in early July). According to this indicator, we are not out of the woods yet on SPX, as the SPXA50R is pushing bear market resistance in the 50 area (will it break out?) and the bullish percentage (bottom of chart) still struggles at its lows.

The Advance/Decline ratio (applied to the New York Stock Exchange, or NYA) is tracked to further corroborate confirmation or divergence. In the chart below, note that a 16-period exponential moving average of A/D (A/D it is too erratic to view on a daily close basis) is uptrending while SPX (dotted line) remains range-bound. Its RSI has also surpassed 50 and recently crossed above its EMA 14. A/D readings below 6400 have tended to precede market bounces.

Building upon our advance/decline review, we gain another perspective on internal market strength with the McClellan Oscillator, a momentum indicator applied to the advance/decline statistics.  

The chart below of NYMO (New York Stock Exchange McClellan Oscillator) shows a positive outlook with NYMO crossing up through its 20-day exponential moving average after forming a higher low in early July.  Note the 20-day EMA is on an uptrend (green arrows show NYMO crossing up through its 20-day EMA).

Also included in the chart above is the NYSE Summation Index, which is a longer range cumulative view of the McClellan Oscillator. We have found when the price of this index crosses its 20-day exponential moving average, there tends to be a change in trend. Despite the whipsaws we see in June and July, the indicator upholds a bullish cross and is a positive divergence for the equity markets.

Internal market strength can also be perceived by reviewing Down Volume vs. Up Volume. Again we use the NYSE (NYA) as our proxy for the US equity markets. In the chart below, note that the Down/Up Volume ratio has declined since early June while the SPX has remained in its trading range. A similar downslope can be seen during the SPX uptrend from the Feb lows through late April. Although the SPX has not performed as strongly as the Down/Up volume ratio would suggest, the decline in the ratio is a positive development and lends support to the positive divergences seen in these internal market measures.

Finally, we assess market sentiment and the fear gauge by reviewing VIX and the Put/Call ratio.  Our interest is to identify indicators applied to these measures that can help pinpoint extremes in sentiment and potential changes in trend.

As for VIX, we view VIX with an RSI (14) below 50 as bullish for equities.  In addition, we look for potential market turns by measuring the gap between the closing price of VIX and its 50-day exponential moving average.  The wider the gap, the more likely that a trend change in equities will occur.  Note that wide gaps in early May, early June, late June and early July (see blue rectangles) preceded a bounce in SPX. Today, there is a modest gap (no extreme reading), yet VIX is bullish at an RSI reading of 40.

Put/Call (P/C) is used in conjunction with VIX as our sentiment/fear indicator.  We see value in tracking P/C extremes as well as extremes in its 13-day exponential moving average.  Note the extreme low in P/C and its moving average in mid-April, which preceded the market drop (P/C is used as a contrary indicator). Spikes can be seen near option expiration dates in the 3rd week of April, May and June. A peak of 1.25 in early July signaled a bounce in equities. Per the chart below, P/C is neutral (there is a large neutral zone bound by .80 at a low and 1.0 at a high), and is not signaling an extreme reading.

After assessing the SPX relative to its trendlines and RSI, measurements of internal strength, momentum and sentiment indicators, we can arrive at a perspective on the condition of the US equity markets as represented by SPX.  Based on all of the above, we are mildly bullish, and would hold off on establishing short positions even though the SPX trend remains down (or at best in a trading range). These signs of SPX strength and positive divergence would next compel us to review the various sectors of the S&P500, to identify where pockets of relative strength are surfacing.  While we try not to pick market tops and bottoms, the sentiment and breadth indicators help us to identify potential market extremes, while moving averages and RSI help to confirm trend and validate price action. As always, price action is the number one focus, as we should use technical indicators within the context of the prevailing trend. But don't ignore the value that various indicators convey in pointing out divergences and early warning signs.

Backing and Filling

Although volume on the selloff on options expiration Friday was not as extreme as it could have been, closing near the lows issued a setback to the recent bounce, representing a sharp 50%+ retracement of the rally from early July.

Equities continue to back-and-fill with SPX closing in on 1060 support (bound at the upper end near 1115 resistance). Some positive divergences remain, including an uptrending MACD, a rather tame VIX (it did not launch to the stratosphere during Friday's selloff), a mildly-bullish put/call and the NY Stock Exchange Summation Index (still reading a buy signal).Some concerns include weakness in small caps (price relative strength has fallen to support at their EMA 34), and resurgent strength in Staples vs. Discretionaries.

We will continue to monitor price behavior with the expectation of a trading range/upward bias in the averages.

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Positive Developments

One gauge we use in determining the internal strength of the markets is to assess the number of fundamentally strong growth companies forming solid bases or breaking out from trading ranges. In reviewing our evening list of over 5,000 equities and ETF's, we have identified a relatively large number of "buys."

Several equity ETF's, including efa, ewt, eem, epi, sectors such as xlp, dba (significant moves in agriculture including sugar are driving this one), xlu, smh (a motley combination) are showing a pickup in relative strength. Not all equitiy indices are in downtrends.  Although the Dow and SPX have yet to break their downtrends from the April 26th high, they appear to be forming a back-and-fill formation.  With today's recovery from early losses, the market mood has shifted in favor of the bulls.

We are not fully committed on the long side, however. Interesting to note strength in bonds today along with the recovery in equities. We plan to commit 60% long equities to take advantage of what might be a 2-4 week ride, protecting along the way with trailing stops.  Gold is looking like an interesting short at this time.

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A Cautious Rally

The bounce since early July has been on weak volume (in part seasonal), as the trend remains down from the April 26th highs. RSI and the Bullish Percentage indicators are pushing up to their bear market extremes (i.e. we have not seen a 95% bullish percent reading since the solid uptrend that ended in late April, and we are nearing a bearish bullish percentage extreme near 45, with the current SPXBP reading at 34. Treasuries remain strong and have consolidated a bit from their highs, inviting a possible entry point for longs).

We also have Dow Theory confirmation of a downtrend as both the Dow Jones Industrials and the Dow Transportation Index print lower lows and lower highs. Advance/Decline ratios (NYA and the Nasdaq) are approaching highs similar to those at peaks during the March 09 - April 10 uptrend, indicating internal weakness as the indices themselves are at lower highs.  And our favorite NYSE McClellan Oscilator seems to have neared a peak similar to those experienced at index peaks during the same March 09 - April 10 time frame. When internal market strength pushes to previous highs without price similarly reaching previous highs, one must remain skeptical about the current rally.

A positive we have identified is the growing number of ETF's and individual company stocks that are generating buy signals (some on higher volume); when we see a growing trend of such signals, we cannot ignore the possibility that this activity is a precursor to a trend change. 


Our strategy has been to take partial profits on long positions and edge into short positions, as we have shifted our stance from bullish (bounce) to neutral-bearish as the rally unfolds. We are prepared to reverse this strategy should the buy signals continue to accumulate.

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Downtrend continues with a few positive signs

Significant internal market weakness suggests that any likely near-term bounce will invite opportunities for further shorts. As major trendline support and the February lows have been broken, we look toward a new significant level of support based on the rally from March 2009 retracing 50% of its gains. That would put the S&P500 near 950 (another 7% lower from Friday's close).

Put/Call did not extend into extreme bearish territory (which would be a contrary indicator and supportive of a rally), as it now sits in modestly bullish (bounce?) levels. The NYMO bullish cross noted previously, was negated last week and further supports the market's internal weakeness.

Relative strength of staples vs. discretionaries surged last week, as defensive "safe" havens are sought. Supporting the bullish case, small caps continue to outperform large caps and growth shows relative strength vs. value.

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Potential for resumption of the downtrend increases

Breakdowns in price versus moving averages (both SPX and Nasdaq have fallen below their respective 200-day moving averages) as well as weakeness in the internal strength gauges (particularly a setback in the McClellan Oscillator, which gave a bullish reading last week) have damaged the market rebound from early June lows.

We are less confident that the SPX will be able to retrace 50% of its decline from the April highs (to the 1130 area) and will set tight trailing stops on long positions, hold off from adding longs unless a convincing resumption of the rebound occurs, and gradually add short positions.

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Bullish bias persists

Several indicators depicting internal market strength are assessed each day as we tour through the financial markets.  On Friday, we noticed that the McLellan Oscillator applied to the New York Stock Exchange index crossed up through its 20-day exponential moving average. A cross through this average has previously market intermediate-term turning points in the S&P500 (the last cross was down during the final week of April).  See the chart below (click on the chart to enlarge).

A other indices have firmed and crossed up through important moving averages, we maintain a bullish bias and  will set trailing stops as this rally unfolds.

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Impressive bullish charts despite rally on weak volume

Although volume on this rally has been wanting, most of our sentiment and market breadth indicators, as well as equity index prices relative to their February lows and important moving averages, are solidly bullish.

One highlight is the NYSE Summation Index (NYSI) relative to its EMA 20; note the chart on the Stockcharts.com Market Tour that shows NYSI closing in on crossing up through its EMA 20. In the past, this has identified significant equity turning points. Let's see if that cross comes to fruition.

Small cap equities have also regained favor as risky assets find a bid.

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Improving price and technicals mask light volume and weak intermarket developments

Stocks trading over their 50-day moving averages recently crossed up through their EMA 10, bouncing up from extreme lows (near 5%) not seen early 2009 near the market lows. Put/Call remains cautiously high (a contrary indicator) while the indices base near their February lows.

Sector-wise, our biggest disappointment rests with financials. Their price relative vs. SPX remains in a downtrend and portends risk to this rally. Related to financials, credit spreads in corporates vs. Treasuries are expanding; corporate bonds price relative vs. Treasuries has been weakening and in the past has foreshadowed weakeness in equities.

A curious positive divergence is industrial metals price performance (as seen by copper) vs. bonds. Although copper prices have been falling and bonds rising, RSI has recently favored copper, pointing to a possible short-term trend change.

With these mixed signals, we are not anticipating a particularly strong bounce from current levels. Our high-probability SPX target is 1115-1125 (Friday's close was 1091), or 3% higher.

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Short-term bottoming process continues

The equity markets continue to support our observations noted earlier (see June 6 comment). A few noteworthy considerations:

• The February lows are holding. A continued basing pattern around these lows will enhance the significance of this support level.
• Nasdaq's relative performance has been waning relative to the S&P500, a sign that the risk profile is shifting to the "bluer" chips. Note in our Stockcharts.com Market Tour that small caps performance has begun to trail large caps.
• Typical seasonal strength in June/July
• The dollar, which has trended inversely to stocks, has hit resistance at its April 2009 highs (while MSCI Pacific index finds support at the Q4 08-Q1 09 highs).
• As for market sentiment, the Volatility Index (VIX) closed below the RSI 50 level (albeit slightly) while Put/Call remains stubbornly high (both contrary indicators).
  

Basing pattern in place

SPX remains caught below its 200-day moving average but sits at support at the February lows. RSI is nudging its way higher in a modest positive divergence. Sentiment indicators reached extreme readings (a contrary bullish sign), however, internal damage to the market suggests a need for more time to base rather than an impending bounce in equities.

We track the McClellan Oscillator (NYMO) for signs of market extremes. Normally, we would see a bounce in equities as this indicator rises from an extremely low level. Recently, this indicator hit an extreme low and bounced with little improvement in the equity markets. A similar reaction was seen in Nov 09 when SPX remained range-bound until it broke out in Dec. Put/Call remains at a high extreme (bullish) and likely to trigger a bounce in equities.

Value stocks have recently surpassed growth in relative strength (measured by the Russell 2000 growth and value indices). Small caps have also maintained favor over large caps, although a divergence can be seen as small cap RSI is weakening (and RSI for large caps recently reversed upward from oversold under 30). This could suggest the move into large cap value for safety.

We expect equities to remain choppy and form a longer base before embarking on another leg upward. We expect that any positive macroeconomic or global news will propel the markets higher, and we suspect that negative news may begin to have a more muted effect as equities seek a firm footing.

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Bullish Bias

As equities struggle to find support at their February lows, various measures of breadth and sentiment recently printed extreme readings,favoring a bounce in equities. The 13-day EMA of the put/call ratio, for example, has been over 1.10 since early May, suggesting continued fear, desire to protect gains and outright bearish bets. This indicator reached these levels in October 2008 (as equities swooned) in the midst of much more severe economic conditions. The dollar also appears to be forming a short-term top; its reversal may lend support to a short-term uptrend in equities. Oversold foreign markets also appear to be settling into support zones.

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Short the bounce

As we believe a top has been reached in the rally since March 2009 (the top was achieved in late April), any bounce from today's deeply oversold environment will invite further shorting opportunities. The weekly charts in the major indices have started to break rising uptrend support. We suspect any bounce will be tepid.

Weak market breadth and high volatility support a short-term bounce. VIX has widened the gap from its EMA 34 (extreme gaps in the past have preceded market turns). The Put/Call ratio closed at its highest since November 2009 (while the equity markets were in the throes of capitulation), and its EMA 13 closed above 1.0 (again not seen since November 2009).

The dollar, which has been moving inversely to equities, appears to be forming a short-term top, another potentially bullish sign for stocks.

We plan to go short-term long with tight stops in preparation for a continuation of the downtrend, reversing to short for the intermediate-term when the expected bounce is exhausted.

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Neutral bias

Market breadth was so excessively weak following Friday's sell-off, that even without the events in Europe, we would have expected a bounce in the near-term. Development in Europe accelerated that bounce in a convincing way. We expect the market to retrace a portion of this rise before moving higher.

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Marking Time

Equities continue to push toward new highs; advance-decline stats have improved as market participation in the uptrend widens. An interesting deterioration in growth relative strength vs. value suggests repositioning (we have not seen the move from small caps to large caps, but there has been much talk about that recently -- large-cap, dividend-paying equities). Put/Call ratio (particularly its EMA 13) has been downtrending while VIX remains in the basement, both cautionary indicators.

Gold and the Dollar have move in tandem (up) since early 2010, which in the past has preceded a decline in treasuries (which are looking wobbly these days as rates firm). Corporate bonds (LQD) have fared much better as retail funds have pushed into this sector.

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Risk/Reward favors caution

No doubt the equity markets have been on a bullish run that appears (based on market internals) fragile. We continue to favor tighter trailing stops on longs and partial hedges on short positions.

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Conflicting Signals

Although the equity markets have reached new recovery highs, our three major concerns of this rally are the following:

1. Advance/Decline line has fallen, diverging from the new highs (see NYAD and NAAD charts).
2. The NYA McClellan Oscillator, one of our favorite indicators, has fallen below its EMA 10, behavior that in the past has marked short-term market tops).
3. VIX remains complacent, well below its EMA 34. We have found that large "gaps" in VIX price vs. its EMA 34 have preceded market turns.

We cannot ignore the trend, and will not turn aggressively bearish unless price and volume action warrant. Picking tops and bottoms is a challenging exercise!

The recent strength in the dollar (our favorite bullish market right now), could wear on equities (as the two markets have been moving inversely to each other. This also bodes negatively for gold and commodities.

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Waning Rally

Divergences in Advance-Decline ratios (both NYAD and NAAD, as they have been declining as the averages reach new highs, as well as the continuing gap in VIX vs. its EMA 34, encourage us to hold off adding to long positions, and tighten stops (speculative shorts have been added). We don't plan to turn aggressively bearish unless the price action tells us to. Remember what Martin Pring says, "technical indicators should be used in the context of the prevailing trend."

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Siesta time for Bulls

A deterioration in market breadth, a complacent VIX reading in the teens, and overbought RSI readings all suggest that the reward/risk favors standing aside from pursuing long positions. We recommend tightening stops and establishing some short exposure.

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Neutral with a Bullish Bias

Not much change from our commentary last weekend. Building internal strength favors sticking with the trend, even though volume on the upside has been lackluster. Relative strength favoring small caps is encouraging for further upside, as traders embrace more risk. SPX approaches its January high near 1150. Nasdaq has exceeded its high as RSI peaks above 70 (price relative also excels). Our one major concern remains VIX, which settled at a low 17.4, as price falls well below its EMA 34.

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Cautiously Bullish

The weight of the evidence suggest a neutral to bullish bias, as the equity markets appear to be consolidating rather than correcting.

SPX sits at firm resistance near 1100; positives include climbing RSI (Above 50 now), and a bullish cross-over in both BPSPX and the McLellan Oscillator (see charts for these indicators). This resistance at 1100 has been a tough one to beat; it also marks a down trendline from the 2007 highs. Nasdaq looks stronger than SPX (and its bullish percentage crossed above its 10-day EMA). VIX remains in the doldrums (and bullish) and put/call is neutral. XLF (financials) have gained in relative strength. Staples have also fallen behind in relative strength compared to discretionaries, another bullish sign, and small caps have leaped ahead of large caps. Finally, a pause in the dollar's strength could bode well for stocks (continuing their recent inverse correlation). This evidence all points positively for equities.

A negative is advance/decline for both NYSE and Nasdaq, representing divergence from the flat to modest uptrend in their indices. This bears watching, but simply may be a sign of consolidation.

Note, there is a very interesting Elliott Wave alternative interpretation taking hold that suggests the rally from March 2009 lows is the start of a new secular bull market (meaning that an ABC correction ended at C in March 2009). This would suggest that the rally from the March bottom was (and still is) Wave 1 of a new impulsive 5-wave advance. This would also suggest that Wave 2 (corrective wave) would retrace a portion of this advance (perhaps we are in Wave 2 now). We are not fully convinced of this view, as secular bull/bear markets tend to last on average 16 years (this one could be viewed as 10 years-old from its start in 2000). We will respect this viewpoint but rely on our own objective chart analysis.

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Where to Seek Alpha?

So where do we go from here? The equity indices bounce from oversold seems to have played out as breadth and momentum indicators have now become overbought, while volume on the upside remained weak. Retracement levels from the early February lows are near typical turning points, even though the major indices have recaptured their 50-day moving averages (and sustained from falling below the 200-day). VIX has settled at support near 20 (where it has landed 3 times since Sept 2009).

It's encouraging (for bulls) to see the strength in small caps, a sign of some interest in more aggressive positions (this could be a play on a strong dollar, which would more negatively impact large caps). From a price relative perspective vs. large caps, small caps are near their highs last seen in September 2008 (and exceeding their September 2009 high). Value is also gaining on growth, as cautious investors seek to reduce risk. Another positive is financials (XLF) appearing to form a price relative bottom vs. SPX (a slight uptrend can be seen as RSI nudges toward 50).

The dollar looks ready to take a breather; although it had been moving inversely to stocks, that correlation has shifted of late (probably driven by higher interest rates). Although Treasuries are looking sick, higher rates would instill a positive aire as economic indicators continue to turn around.

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