Saturday, December 25, 2010

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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Thursday, December 16, 2010

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

Saturday, December 4, 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.

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