Topping indicators spell caution for bulls

Each week, our Market Tour reviews select indices, sectors, sentiment and volatility readings, and intermarket relationships, in order to gauge the reward-to-risk of all asset classes. There is no doubt that bullish momentum and the Street's need to participate in the uptrend has driven equities to the higher-end of our comfort zone. As traders and investors, we look for reward-to-risk opportunities with a minimal 3:1 reward/risk profile. This is determined largely by technical analysis factors, taking into consideration support and resistance and momentum indicators.

At this juncture of the rally in equities, an expected pause (if not correction) causes us to lighten up on long positions and establish contrary (short) positions in equities. One of our strategies has been to write covered calls on profitable long positions, expecting either to pocket the premiums as the long positions weaken, or have such long positions called away (leaving some money on the table). In reviewing this past week's action, we intend to continue this strategy.

Technical Analysts will see that the S&P500 (SPX) has recovered a bit over 62% of its decline since the peak in 2007 (61.8% is a classic technical indicator retracement benchmark). This may be a ripe time for a pullback in equities.  In addition, SPX has seen a negative divergence in RSI (a lower high as price climbed to a higher high), and MACD has printed a negative cross-over (see chart below). Although at the end of the day, PRICE is the important indicator, such momentum statistics are cause for pause and caution.

The Nasdaq displays a slightly weaker position vs. SPX, with more pronounced weakness in RSI and a negative MACD cross-over. Nasdaq underperformed SPX last week.  See chart below:

Although the price trends in equities remain up, we have denoted our comments on our market tour mostly neutral (rather than bullish) given the extent of the rally and the negative momentum indicators.

Here is a list of other positives and negatives as we review sentiment and intermarket relationships:

Positives:

1. McClellan Oscillator statistics remain positive.  The indicator remains above its moving averages (13 and 34-day) as the Summation Index remains above 400 and above its 20-day exponential moving average.
2. Relative strength is improving in Financial stocks.
3. Continued strength in commodities.
4. Outperformance of corporate bonds vs. treasuries.
5. Continued strength in small caps and growth stocks.

Negatives:

1. A downtrend in relative strength in Consumer Discretionary stocks while Staples remain firm (a relative strength bottoming pattern for Staples appears to be emerging).
2. A potential negative for equities was strength in 30-year Treasuries last week. A short-term bottom for treasuries could precede a setback for stocks, as these asset classes have correlated inversely.
3. From an Elliott Wave perspective, SPX apears to have completed the final 5th wave of an impulsive rally, which would suggest a correction forthcoming (its retracement of nearly 2/3 of the decline since its peak in 2007 is an additional concern for bulls).

Neutral:

1. VIX and Put/Call have turned neutral. Although it is interesting to note that VIX has risen along with equities, suggesting a bit higher risk premium and potential volatility in equities.

Based on these observations, we are not embracing a bullish stance as the crowd has, but will sit on the neutral side with some hedged postiions in shorts to take advantage of an ancitipated pullback as we commence the New Year.

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Bob Palmerton - January 2, 2011