A Respite For The Uptrend?

Technical analysis pundits have been sounding the alarm of excessive optimism and divergence in the equity indices, clamoring for some sort of pullback. So often, analysts can easily fall into the trap of "too many indicators" studied in "too short a timeframe," generating frequent trades that, at the end of the day, were no more profitable than taking a longer-term position consistent with the intermediate term trend.

Our "trend-following" approach to equities rests on following a simple system tracking the S&P500 (SPX) against a Relative Strength Indicator (RSI) and its moving average, and a moving average of SPX price. This simple system has captured the major intermediate-term trends despite the fears of overbought markets and divergences we speak of here. 

Even though following (and sticking with) the major trend is the key to investment success, the trend ocassionally sees corrections which represent equity drawdowns in our trend-following approach. Staying consistent with the major trend, but hedging with futures or options when the outlook gets dicey, is an ideal strategy.

Our Market Tour indicators help us gauge the reward/risk of the market at any time, and the propensity for a short-term correction in the major trend (our higher-level RSI/Moving average study noted above keeps us on the right side of the market nonetheless). As for our Market Tour indicators, here is a summary of the positives and negatives. After reviewing these indicators, a higher level of caution is warranted with regards to long equity positions.

Positives (regrettable for Bulls, not too many):

1. Clear uptrend sustained in weekly and daily charts of major indices. Recently, selloffs earlier in the day have often recovered by the end of trading.
2. Nasdaq relative strength beats SPX (technology has often led uptrends and we look for this sector to lead the sustained advance in equities).

Negatives (more than our usual tally):

1. Divergence in momentum indicators (the buying strength is waning).
2. Low VIX marks complacency and is worthy of watching for a sudden shift in equity direction.
3. Advance/Declines (NYSE McClellan Oscillator indicator -- NYMO) flashed a minor warning sign (NYMO fell below its 13 and 34-day moving averages on Friday).
4. Financials felt a bout of underperformance this past week as foreclosure debates persist and the overhead risk of bad mortgage debt remains.
5. Decline in CRB (gold included) as the dollar strengthens. The US dollar and equities have largely moved inversely during the rally from 2009; a change in trend can spell trouble for equities. Gold may be leading the way to a decline in stocks (gold and stocks have moved largely in tandem), as GLD fell about 4% last week. An upward bias in US interest rates and continued Euro risks fostered by sovereign debt concerns have helped the greenback firm.
6. Slight decline in corporate bond prices vs. Treasuries. Traditionally, a spread in bond prices above Treasuries has been positive for stocks.
7. A decline in small caps vs. large caps on the week, denoting a bounce in the "risk-off" trade.  

In addition, we follow an "economic strength" indicator as defined by the relative price performance of copper (our proxy for industrial materials and therefore industrial growth) and US Treasuries. When the trend of this ratio rises, we are in a favorable growth, if not a potentially inflationary period. This trend has been positive since March 2009, along with equities. A minor risk (suggesting a pullback potential) has been noted as this ratio is bumping up against resistance around the 3.50 area seen in 2006, 2007 and 2008. Each time it hit this level in the past, a correction of 15%-30% occurred.  See the chart below:

In conclusion, once again we sit at a potential turning point in equities. Friday's mixed employment report provided a bit of a wake-up call to the bullish enthusiasm that has graced equities since early December. There is no telling from the momentum and trend indicators we watch, as to what magnitude of a trend change we might see. The markets are way overdue for a consolidation or a correction. We feel that these indicators beg for caution and continued hedging of long positions for the time being.

Click here for our Market Tour on StockCharts.com.

Bob Palmerton - January 9, 2011