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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