It looks to me like we could be forming the end of a blow-off rally. It’s difficult to measure how high stocks could go from here, but there are some clear shifts in volume, world market trends, and sector rotation that are signaling this bullish trend is coming to an end over the short to intermediate-term. Investors should invest more cautiously today than a few months ago due to the shift in momentum. Don’t be left holding the bag when valuations come back down to normal.
Let’s start with foreign markets and work our way back. When investors got word that the Chinese banks were deciding to slow lending in August, the Shanghai Index fell 21%. If the Fed announced last Wednesday they would be removing some of their accommodative policies, there’d be no doubt in my mind we’d be trading below 1,000 on the S&P 500 at this time. The Shanghai Composite is recouping from that correction at 3175 after bottoming near 2700.
The South Korea Seoul Composite is another market to watch closely with many technology names listed there. The 13-day has crossed the 34-day exponential moving averages (EMA) to trigger a sale signal. The composite is continuing to stay below the two moving averages giving a more solid confirmation of the signal. To cancel the signal, we would need to see the composite move back above the averages within the week.
As the financial sector led us out of the March bottom due to changes in mark-to-market, any underperformance at this present time would not help the bullish case for the stock market. The financials have underperformed the S&P 500 since mid October. The bulls definitely need the financials to reignite a fire under their stock price if this stock market is going to regain some of the momentum we saw in the 2nd quarter and in July. Since the July rally in stocks, financials have stalled relative to the S&P 500.
Concerning the stock market itself, distribution was the name of the game in October—at a higher rate than we’ve ever seen since the start of the rally. When fewer participants create new highs and fewer participants reach back above their 50-day average (an intermediate-term trend indicator), a bull should start to be concerned. These are early signs of an end to a bullish trend.
The first indicator of a change in momentum I see is a change in volume trends. After the July rally, volume declined in any pullback in the market. As of the 5% decline in October, volume expanded in the sell-off as shown below.
In addition to a shift in volume characteristics, breadth was large with a significant number of issues participating in the correction. Breadth expanded all the way to the end from 50% of market participates to more than 90% of issues in two days of heavy volume on 10/28 and 10/30.
The final note regarding momentum is a warning in new highs vs. new lows. If we show any divergence (a drawing apart – Merriam-Webster’s online) between a new price high in the market and the number of issues reaching new highs over the next few weeks, it will be another warning that participation in this rally has shifted from the troops to the generals (blue-chips). This would be a sign of a shift in portfolio strategy to a defensive one.
While we show a real shift in market momentum in the character of October’s pull-back, previous trends are still intact. The dollar’s bearish trend is intact, gold’s bullish trend is intact, and stock’s bullish trend is intact. The transports gave us a scare last week with a close below support, but in swooped Warren Buffett to save the day. The new high in the industrials today will need to be watched closely over the next week to see if the transports can follow suit, as well as the Nasdaq Composite and the S&P 500. Long-term support and resistance on the S&P 500 is 1020 and 1100 respectively—the levels traders will be watching this week.
Eventually, the great fair-value debate in August is going to be answered. Jeremy Grantham is putting a fair-value on the S&P 500 at 860. With an October 19th high, that places the market 25% overvalued. How much higher can we push P/E ratios without seeing growth in earnings? Earnings surprises are great and all because they’re not priced into the market (thank you pessimistic analysts for three baked in the cake bullish quarters), but valuations will gravitate prices back to reality. This also rings true from a technical analysis basis with a lot of risk between the 200-day average and the current price as shown below:
