Indices Brushing Bear Dirt Off Their Shoulders

The Dow Jones Industrial Average, Dow Jones Transports, Russell 2000, and the S&P 400 (mid-cap) are currently near their highs for the year. As my colleague Tom Smith has explained already this week, that’s no small feat considering what we’ve been through in the first quarter of the year: regional instability in the Middle East, an extreme earthquake and tsunami disrupting the 3rd ranked economy in the world, gasoline up 25 percent, and overall commodities pushing higher and higher. If rappers studied the markets, I’m sure Jay Z would tell us, “You gotta get, that, (bear) dirt off your shoulder”. When markets brush off bad news, like they did with the events above and yesterday’s poor economic releases, you’re in the presence of a bull market.

The 6.3% decline in the Dow Jones Industrial Average between February and March was well within the standards for a bull market correction (less than 10%). As bearish as investors turned on tech through the Japanese economic disruption, the Nasdaq Composite only lost 7% from the February closing high to the March closing low. Because the run in the markets since the September low was so strong, it is no wonder we’re testing the market highs for the first time.

As I mentioned in “The Trend is Your Friend…Until the End (Cont.)” it is important to note that while the intermediate trend was broken for the S&P 500 on March 1, that didn’t guarantee that a new downtrend was beginning. When trends break, all that means is the previous trend has broken. That’s it. Too many times investors and traders especially read way too much into a trend break; that a reversal is the only answer. Well, no, a consolidation is also a possibility, especially when the trend was as strong and lasted for as long as it did since September 2010.

The Elliott Wave principle has many key rules that help me in identifying trends and correction behavior. Impulse waves that determine the direction of the main trend develop in 5 waves: three waves in the direction of the main trend and two counter waves. One of the key rules of how trends develop is that the fourth wave never enters the price territory of wave 1. Case in point: the hourly chart on the S&P 500. The current rally has broken through the end point of the first leg down in the February correction; therefore, a new downtrend has been written off as a possibility.

If a new downtrend has been denied, what kind of behavior is the market exhibiting? There are only two possibilities now: consolidation or resumption of the primary trend up. If we are unable to break to new highs in the market, then it’s possible the market wants to continue to take a breather and work off the overbought readings and ultra bullish sentiment we saw in January and February. If a consolidation were to continue, it would most likely look like something Ralph Nelson Elliott called a flat correction that looks like this:

Bull Market Flat Correction

While a continued consolidation here is a possibility, my gut tells me the market is acting pretty bullishly here. We’ve basically rallied straight up since the March 16th closing low that was kicked off by a major buying volume day on March 18th in which more than 90% of the S&P 500 and the NYSE were advancing on high volume. Volume has dropped off since that big day, but that’s fairly normal. Volume spikes at tops and bottoms according to distribution and accumulation respectively.

In the very short-term, the market is overbought. 90 percent of the S&P 500 stocks are trading above their 10-day moving average. It’s likely the market will take a pause here near its highs to reevaluate the primary trend higher. The bullish sentiment on the market has already paired back some in newsletter writings and in the put-to-call ratio over the past couple of months; so the correction is doing what it set out to do. An important indicator I’m watching is whether the 14-day RSI on the S&P 500 can make it back above 60. A reading of 60, on the 14-day RSI, tends to rebuff bear market rallies and bull market corrections. A break above 60 towards 70, while overbought, would be a sign of strength that points towards the resumption of the bullish “character” in the market – not that we haven’t already seen a few of those with a MACD buy signal and a price above the 50-day moving average.

The bullish case scenario is that we barely hiccup near the old highs as Wall Street heads into the earnings season. A break above the February 18th top is very bullish for the market. It means we’ve had a higher low (November 30th was the last trough with a close of 1180) confirmed by a higher high. So far, there doesn’t appear to be any divergence between the transports and the industrials as both Dow Jones Indices are currently near their respective highs. We haven’t had a high volume 90 percent down day since March 16th on the NYSE. Selling pressure was exhausted on that day it seems. Buying pressure has been steady on light volume since March 18th, which was also the case when the market rallied after the November 2010 correction. I don’t expect to see big buying pressure come into the market until we have cleared the old February highs by 1-3 percentage points.

If the market is heading higher from here, new buyers might be interested in what’s performing. Looking at the sector performance in the fourth quarter of 2010, the performing sectors were:

S&P 500 up 10.1% in that period

  • Energy – 20.78%
  • Materials – 18.16%
  • Financials – 11.68%
  • Industrials – 11.15%
  • Information Technology – 10.06% (market perform)

Over the past quarter, the market has been a lot more selective, which is not a positive sign for the long-term (as of March 28th):

S&P 500 up 4.45% in that period

  • Energy – 14.75%
  • Industrials - 6.73%
  • Everything else underperformed

Overall, sector peformance points to brutal selectivity and the need for a disciplined hand in managing this market.

About the Author

Wealth Advisor
ryan [dot] puplava [at] financialsense [dot] com ()
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