It was a fairly uneventful week from a technical standpoint. Volatility is taming, volume is becoming anemic and negative divergences are deepening. That said, price (the most important arbiter) fails to indicate any intention that it wants to correct. Typically, markets that don't want to go down resolve upwards. And "overbought" conditions can either work their way off via time or price.
In other words, one could interpret the information as bullish or bearish depending on their perspective.
A number of weeks ago I outlined a few of clumps of technical resistance that one could use in timing the end of this rally. The first clump was in the 940-950 area (basis S&P 500). The next was sitting just above 1000. And the final levels seemed to reside around 1075-1100. One should always be wary of an irrational market to persist longer than initially believed possible. And it should also be mentioned that corrective waves have a tendency to last a minimum of 1/3 the duration of the preceding secular trend. Marking the beginning of the trend as Oct of 2007, the first wave lower was 17 months in duration, meaning that this corrective rally should last at least into the end of the summer. Sharp pullbacks, however, can easily interrupt this path. And that is my primary expectation - that we see a sharp pullback of 10-20% in the near term, followed by a late summer challenge of, and perhaps exceeding of, the recent highs (S&P 956).
It is possible, though, to mark the "beginning of the nightmare" as May of '08 if looked at in real dollar terms. The May highs came very close to matching (and for some indices exceeded) the highs of October '07, when normalized for the dollar's coincident collapse during this period. In this case, the decline lasted only 9.5 months (42 weeks) and our current rally (of 14 weeks) makes for a precise 1/3 retracement in terms of duration. As I mentioned, one can always manipulate the data in favour of their prevailing opinion and one must be aware of the "confirmation bias" that this sort of analysis can provide.
Perhaps most concerning for the bullish case, is the persistence of negative divergences in market internals. Advance/Decline ratios, volume, RSI and the number of stocks above their 50 day MA are all displaying weaker numbers than they were in early May when the S&P was a full 4% lower than last week's highs.
The 50 day MA of Advance/Decline stocks is below.
One would surmise that amid all of the talk of "green shoots" in the housing market that the homebuilders would be displaying strong characteristics considering that they were the sector most heavily hit in '08. However, upon further review we see that the hommies are displaying relative weakness over the last 6 weeks. If we were to believe the pollyannas in the media that an economic recovery was imminent, residential investment is one of the leading indicators to be watching - and this would be visible in the homebuilder stocks. This is not the case.
And pray tell, what is one to make of the continuing non-confirmation of perhaps the most important sector any recovery would be dependent on? I'm obviously referring to the banking sector. Without an organic recovery, which would obviously take years to liquidate, reallocate funds and begin production, the only hope for the middle part of a "W" shaped recovery would be a continuation of the insane lending practices of the middle part of this decade. If this lending were indeed taking place and it was perceived to be profitable for the banking industry, bank shares should be massively outperforming the major indices. Again, not the case.
In conclusion, I do not find it difficult to conceive of enough reasons to believe that the present rally is over, or at least poised for a very sharp correction in the near term. However, we should not forget that the specter of quarter-end looms and performance anxiety of major fund managers is a force to be reckoned with. This could easily push the aforementioned divergences to new extremes as managers tinker with their portfolios, playing to their fairly P.O'd client base. That is, managers may decide to switch out of underperforming sectors into the outperforming in order to make themselves "look smart" when the time comes for them to begin writing "Dear Investor" letters.
I'm officially on the fence. I've allocated 50% of my intended capital to short positions and will add the other half at higher prices or not at all. Do note that this is not an explicit recommendation to get short. For those interested, my preferred vehicle for shorting is LEAP PUTS with a Dec '10 expiry on the S&P. This gives me more than enough time to realize my expectation. After learning the hard way in '07 that a market can climb a "wall of worry," the time premium is a price I'm willing to pay. Just thought I would share.
Have a great week!
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