This rally looks technically ok - for now

Three weeks ago, I called for the end of the little correction we had experienced in the beginning of the year, and the reason was mostly technical. Today, I cannot find a technical reason to call for the end of this three week old rally: market breadth and internals are quite good (see this post to understand why these indicators should be followed). Sentiment used to be ultra-bullish, which was bearish. It is not anymore. Most of the liquidity indicators I follow have turned up. Volume is lacking, but it has been lacking since the March 09 bottom.

The fundamentals however are deteriorating. Leading economic indicators around the world look toppy, Greece is only the beginning of a multi-year (multi-decade ?) long round of sovereign credit problems, and the financial sector is likely to face renewed troubles due to fading official support and high default rates in commercial and residential real estate (why does everyone thinks that because banks are paying huge bonuses then they must be fine? This is simply flawed logic). Add to this stretched valuations and soon-to-be fading policy stimulus, and voilà! you have a recipe for some choppy waters in risk assets.

But for now, Mr. Market just doesn't seem to care, and the path of least resistance seems to be up.

Reversal?

After opening and spending most of the day in the (deep) red, most risk assets, including equities, managed to turn out a small again gain last friday. This is what technical analyst call a "key reversal day", and is short-term bullish. However, the fall of the past few weeks has done a lot of technical damage: supports and trendlines broken, oscillators and indicators rolling over, etc. As such, the technical picture is not yet supportive of a sustained advance. Stay tuned.

A few words from veteran analyst Richard Russell

I want to remind subscribers that (in my opinion) we are now dealing with a bear market rally that is in the process of topping out. The actual bull market topped out back in 2007. Therefore we are now dealing with a rally in a bear market that appears to be topping, and there is a world of difference. A bear rally that is topping out will not give off the same warning signals that a dying bull market will. Thus, many analysts who are still bullish are looking at the wrong thing. They don't see the usual signs of a bull market topping out because that is not what is happening. And this is keeping them bullish. What we're looking at is a rally in a bear market that is in the process of topping out.

Top or not, I don't see the point in having much, if any, exposure to equities at these levels of valuation (see most of my previous posts... this little correction we've had should come as no surprise to regular readers, and it wouldn't be much surprising either if it develops into a full fledged down leg. Upside potential is very limited for the broad U.S. stock indices).

Stock market technicals

In this post I will take a look at the recent internal behavior of the U.S. stock market and explain why I follow these indicators, using the "army" metaphor to describe the market. The comparison is simple: you want to "buy" an army that is winning the war, and "sell" an army that is losing. I know of four kinds of indicators useful to assess the sustainability of the performance of the stock market (i.e. is the army progressing or receding):

• First, are the different sectors of the economy all performing well? You would be wary of an infantry progressing while the Air Force is taking a beating, would you? The same holds true for the stock market. This is why is watch the Industrials, Transports, Utilities, Financials, Techs, etc. Important divergences in the behavior of these indexes signal trouble ahead. This does not seem to be the case right now.
• If the generals go on an offensive without support from the troops, what's going to happen to them? You want to see that the troops are following the generals, that is, you want to see as many stocks advancing as possible. This is referred to as breadth. Breadth recently has been quite good, although not as strong as it was this summer.
  
• Next, imagine that your army is making progress on the front, but at the same time the daily number of your soldiers getting killed increases. Furthermore, the enemy is suffering lower casualties every day. What is then the quality of your army's recent advance? Most likely, it is not sustainable. That is why you want to monitor the number of kills (stocks breaking to new highs) and deaths (new lows). These are referred to as the stock market internals, and there's no complains to be made about them at present.
• Finally, you want to monitor the exhaustion versus restfulness of your soldiers. If, after an advance, your soldiers still have energy left, it is more likely that this advance can be sustained. You monitor this by looking at the number of stocks above their moving average level: stocks above their moving average tend to revert back. At present the market seems to be very overbought on that basis, although there has been some progress in the past couple months, and this is constructive because it happened while the market worked its way higher.
  

Alright, there are other kinds of indicators, such as volume. I haven't been able to fit it into my metaphor, but it is quite important, and it hasn't been really good, which brings support to the view that the advance since the March low was just a bear market rally. Overall the technical picture is quite positive at the moment, but the overbought condition suggests to me that we are seeing the last stages (the most speculative) of this advance. As such, caution is warranted, while small exposures to put options for hedging purposes are still, for now, more appropriate than outright shorts.

Gold spikes charts update

This is an updated version of a previous post, in which I am comparing the different spikes gold has experienced in this bull market.

As I was saying in my previous post, in this bull market the metal's price has tended to go up in spikes, followed by long periods of correction and consolidation:

 

 

 

 

 Now the latest one:

Following a much better than expected employment report yesterday, gold and treasuries sold off and the dollar spiked up. Now the big question: has gold topped out yet? I don't know and I don't really care. I wouldn't buy in the middle of a spike, because well to be frank, that's a sucker's game: the probability that once the spike is over, the price will go back to lower levels than the current one is very high. I wouldn't sell my core positions either because I believe gold will go higher eventually in the next few years.

Short sellers may have an opportunity to make a quick buck here, but beware that:

1) that unemployment report may be revised,

2) Fed officials may come out in the next few days and downplay it's importance,

3) gold spikes have usually had longer legs then this,

4) gold mines usually top out weeks before the metal and haven't done that this time,

5) finally, doesn't it seem too easy ? I mean, could one single good unemployment report be enough to trigger a top in any large liquid market? If I have learned one thing about the markets, it's that it's usually pretty hard to make money.

Short seller beware.

Equities: short-term caution

Many of the short-term technical indicators I follow have turned bearish in the past few days: market breadth and internals, although having not broken down during the last correction, have not been strong during this week's rally. There were eight up days in the past ten days, and the market is back to a short-term overbought condition.

Since in my opinion, valuation levels do not provide for strong long-term returns, the only case that remains to buy stocks now is that, in the mid-term (a few months), the economic recovery is going to be strong enough to support those lofty profit expectations, but not strong enough that the Fed is going to remove accomodation any time soon. This is a thin line the market is walking. Some call it a bubble.

More on gold (charts)

As I was saying in my previous post, in this gold bull market the metal's price has tended to go up in spikes, followed by long periods of correction and consolidation. If history repeats itself once again (which I believe is the case), gold, which has just broken out of an ~18 months trading range, has recently started a new spike. At which price will it start to correct is anyone's guess (mine is about $1300, but as I said, it's just a guess). Keep in mind that I wouldn't personally start buying here because 1) who knows when the spike will end, 2) the correction is likely to bring the price back to current levels (maybe even below), and 3) the consolidation period is likely to be quite long-lasting. These are the exact same reasons why I'm not trying to trade in an out of this bull market: I'm just holding to my positions. Below are a few charts to support that (click to enlarge)

 

 

 

 

 

November Stock market update

A couple weeks ago I made a case that U.S. equities were overbought and overvalued. We've had a little correction since then, and I've been asked if I think this is the beginning of a sell-off or a opportunity to buy the dip. My answer in a nutshell is: neither.


Stocks (on average, notably if you look at the S&P500) are still overvalued. This, especially in the context of less than goldilocky economic backdrop (see here and here), means that buying at these prices is speculation more than investment.


Furthermore, veteran technical analyst Richard Russell makes a strong case for a deterioration in market technicals (not online):

(1) Far too many distribution days.

(A distribution day is a day when stocks close lower on rising volume.)

(2) The bullish percentage of stocks on the NYSE is declining.
(...)
(5) The Transport Average broke below a preceding decline low October 28.
(6) Sentiment is too bullish regarding the market. Nobody expects this rally to top out and fall apart. Analysts consider it impossible that the March lows will be revisited again. I don't share their opinion.

Well this might not be entirely true: Mark Hulbert's sentiment index isn't showing worrying stubborn bullishness.

(7) My PTI is now only 8 points above its [moving average] and therefore very close to a sell signal.

The PTI is Russell's proprietary stock market indicator.

(8) The Dow, so far, has not been able to close above the 50% level of the 2007-to-2009 decline. The 50% level was 10725.

[10] Whether Lowry's Buying Power and Selling Pressure are spreading apart or coming closer together. Example, if on a given day, Buying Power drops and Selling Pressure rises, the spread between the two widens. That's technical deterioration. Since Oct. 19, the spread between BP and SP has widened by 45 points.

On the other hand, although market internals and breadth have turned a bit weaker in the past couple weeks, they haven't completely broken down in the way I would expect them to if we were on the verge of a nasty sell-off. Plus, in recent days they seem to have stabilized.


In conclusion, my best bet for the short term is that equity indices are going to settle in a trading range and test their recent highs. Whether the highs are bettered remains to be seen, and I am worried that an important top might be in the process of developping. The answer to that story could take weeks or even months to unfold.

Beauty of data-mining...

...applied to technical analysis:

More Russell

On July 8, 1932, the Dow sunk to its final bear market low of 41.22.

As soon as the Dow passed that low, volume on the NYSE suddenly soared to 4-5-6 million shares as the market surged higher. A new bull market had started amid the Great Depression. At that time, nobody had any money. The nation was broke. And yet when the market following July 8 turned from bear to bull, volume exploded. The market in its amazing wisdom, immediately recognized the turn. And from a "broke America," money poured into Wall Street as volume on the NYSE surged. I always wondered where that money came from -- wasn't it remarkable -- and it is a lesson I'll never forgot. When the price is right, the money will be there.

Richard Russell

Which is why I've recommended gold coins. In a funny way, once you buy some coins you are stuck with them. It's so much trouble to buy the coins, that once you buy them and take physical delivery, you tend to sit with them. It's even more trouble to sell the coins so again -- you sit with them. Over time, those who bought the coins and have sat with them -- have done best in the gold bull market. They never traded in and out of the bull market, and they necessarily stayed with the great primary bull trend in gold. In other words, by "doing nothing" they did well.

I'm glad to be able to say "they" applies to me.

Hussman: market internals have gotten a bit better

We've observed a small favorable divergence between the major indices and overall market breadth in recent weeks, as investors have begun to pick the wheat from the chaff. There is no assurance that this process will continue, (...) however, it's a good sign to observe investors being more discriminating about investment quality, because it allows investment returns on the basis of stock selection, without relying on sustained gains in the overall market.

Barron's Magazine

http://hussmanfunds.com/wmc/wmc090209.htm