Here We Go Again???

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The markets have sold off from multi-year highs in some market averages and all-time highs in others. In the glory years a 5% pullback was met with greedy buyers looking to get into stocks they felt they had missed. After the debacle of 2008/2009 many look at ANY move lower in the averages as the beginning of another rout.

Let’s try to see how things shape up both technically and economically in an attempt to guesstimate where this market may go. The technical picture of the market has weakened over the past few weeks. Many of the hot areas of the market have seen pullbacks well in excess of the broad market averages. Bears use this as a sign of imminent doom. It only makes sense that some of the recent high flyers—banks, homebuilders and airlines—have pulled in more than the market. I do not view the action in these areas with as much alarm as those in the bearish camp. Certainly these areas of the market need to be monitored going forward to see how they respond to last week’s weakness. But, in a rotation it makes sense that people take some profits in their recent winners. While the pullback in the market last week needs to be monitored it is too early to say game over.

In the S&P 500, things remain strong but have weakened. The long term trend remains strong. 80% of the members of the S&P 500 are in basing or advancing patterns. There has been an aggressive rotation into blue chip stocks. Many of the most familiar names on offer continue to perform very well. Many healthcare stocks continue to hit new highs on a daily basis. Utility stocks continue to be bought aggressively. REIT indexes are hitting multi-year highs. Investors in the last two industries mentioned are flocking to these stocks due to their dependable cash flows and high dividend payouts. Bears point to the lack of appetite for more aggressive areas of the market as a sign that a downturn is coming. As long as interest rates remain virtually zero there will continue to be an appetite for high yielding total return stocks.

The technical picture for small cap stocks is not as attractive. 71% of small cap stocks are in sound shape technically. This is a function over concerns regarding future growth rates. In this low growth environment investors are reluctant to go too far out on the risk spectrum. This trend has deteriorated over the past few weeks. If small caps continue to weaken it will be a negative for the entire market.

The recent weakness in the technical condition of the market makes the intermediate-term condition less attractive than it has been at any time in 2013. I will need to see small cap issues perform better in the coming weeks in order to avoid a downgrade to the intermediate-term trend.

In order judge the shape of the market, we'll need to monitor some important technical levels. Key support levels for the S&P 500/Dow/ NASDAQ/Russell 2000 are 1538/14,390/3167/908. I give you these levels to monitor each week. It is important we go over the concept of divergences here as they have been very important barometers of the market over the past several weeks. If some, but not all, resistance levels are broken it is a negative divergence and you often see the market averages sell off after that happens. If some, but not all, averages close below support levels, the market has been rallying on these types of positive divergences. When it has looked as if the market was going to break down over the past several weeks, there has been a sell off and then a rally on a positive divergence. Please play very close attention to the action in the markets if we approach the support levels I have given here.

Bears here feel history will not rhyme but repeat. Over the past three years we have seen a sharp spike in the first quarter of the year met with weak second quarter performance. One key thing that has been critical in creating the weak second quarter environment over the past three years is energy prices. We have seen a spike in economic activity in China lead to higher energy prices and that has been imported here in the form of higher prices. These higher prices have served as a tax hike to the consumer and hurt the market. Will this happen again? The price of a barrel of oil is still less than $100. Energy prices did move higher as Chinese economic activity has picked up over recent weeks. I will keep a close eye to see if the theme of higher energy prices in the second quarter plays out again.

Recent weakness in manufacturing and employment numbers over the past week put many investors on high alert. The surprises for several weeks were all positive on the economic front. The last several economic releases have surprised to the downside. Will the recent weakness lead to a sustained period of weak numbers? It is too early to tell.

Many areas of the market have sold off significantly more than the market over the past several weeks. It is critical to monitor the performance of the individual holdings in your portfolio. If stocks you own have come down in an orderly fashion and held support then alarm bells should not be going off. If stocks accelerate to the downside at key support levels and moving averages it is a sign investors are rotating away from those names to greener pastures. Do not become transfixed with just the major market averages. Continue to monitor each name you own and see how it reacts near support.

Earnings season has begun. Companies will begin to report first quarter earnings this week. Earnings season will shift into overdrive starting next week. Quarterly reports, and more importantly, forward guidance will lead to increased volatility over the coming weeks.

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About Thomas J Smith CFA