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.

Click here for the updated Market Tour on Stockcharts.com.

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

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.

Please visit our charts below on StockCharts.com (if you like our work, please vote at the bottom of the page)!

Click here for the latest Market Tour on StockCharts.com.

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.

Click here for the latest Market Tour on StockCharts.com.



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.

Click here for the latest Market Tour on  Stockcharts.com.

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.

Click here for the updated Market Tour on StockCharts.com.

- 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.

Click here for the latest Market Tour on StockCharts.com.