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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