Too Late to Buy and Too Early to Sell

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There wasn’t a lot of driving news this week. Price has been the biggest catalyst of this move. Higher highs beget more highs, which has attracted more bullish sentiment and more believers. Instead of telling you where my imaginary crystal ball is telling you the market will be tomorrow, I’m going to just tell you where the market is. By doing so, we can not only infer that it is too late to be a buyer of this rally, but it is also too early to be a seller. Just because the stock market is overbought, doesn’t mean it can’t continue to remain so – for a while longer.

There are a number of breadth (participation) indicators I use that are at the top of my list of tools to gauge market health. The number one tool is the percentage of companies in the S&P 500 above the 50-day moving average, for intermediate swings, and the percentage of companies in the S&P 500 above the 200-day moving average, for long-term swings. Both of these indicators are flashing overbought conditions. As I’ve discussed in former articles, these can remain in this area for a while or for a very short time. The longer they persist in this zone, the stronger the trend. The longer and stronger the trend, the longer it will take to convince everyone to change their minds about it. Tops are a process, of course.

At this point in time, I’m not that concerned about an intermediate-term reversal that might last only a couple of weeks, but rather a long-term reversal that could last two to four months. Why is that? I’m invested so I don’t need to buy, but I do need to know when to sell. My main concern is how long the market has been in this overbought zone, and how long past rallies have remained here.

When the percentage of S&P 500 stocks above the 200-day moving average rises above 70%, it’s considered overbought. The indicator triggers a sell signal when the percentage of stocks falls below 70%, but I’ve found that if you look for top formations in the indicator, you can get an early indication that breadth is waning and a major turn may have begun.

spxa200r 13 mar 2013

This rally became “overbought” when 70% of the stocks within the S&P 500 were above their 200-day moving average on December 12th. Currently, 88.6% of the stocks within the S&P 500 are above their 200-day moving average, and it shows no sign of reversing. What’s more, I don’t see any divergences in this indicator with the market hitting fresh highs. If there were fewer stocks above the moving average than in February, there’d be a warning, but no divergences exist for this indicator. The February dip on Italy and the FOMC minutes created a pivot low near 83%. A drop below that number would produce an early warning for aggressive traders while an official sell signal would only occur with a drop below 70%.

Is it ok to chase and buy stocks right here based on this indicator? I would say only if you have a very short-term horizon. There are still plenty of stocks which are only just breaking out of bottom patterns. You can especially find them in energy right now – some of the gassy producers to be exact. Natural gas is breaking a key resistance area today and so many producers are breaking out. However, if you’re a conservative long-term investor, I’d say wait for the market to get oversold or at least wait until the percentage of stocks above the 200-day moving average gets to a more neutral reading, near 50%.

Judging by past QE-influenced rallies in the market, that has taken:

207 days - October 8, 2010 to my early warning: May 31, 2011

74 days - January 23, 2012 to my early warning: May 3, 2012

The current rally has been 66 days in the overbought zone (above 70%) with no early warning of a reversal yet. So we’re soon approaching the time period that the market began to correct in 2012 in anticipation of Operation Twist’s scheduled end. At that time we had seen troubling reversals in the Leading Economic Indicators (LEIs) from ECRI as well as in the European Purchasing Managers Index (PMI) and U.S. regional manufacturing data. Yet nothing in my work shows me I should be concerned yet of a long-term reversal. Yes there’s concern over the effects of sequestration on GDP, whether Italy can form a government, or how hard China plans to restrict its housing market, but none of those concerns are showing up on “the tape” yet.

Europe isn’t fixed. The Eurozone PMI was out on march 5th for February. It was down to 47.9 from 48.6 in January. Although the number came in above the flash number, this is still a troubling trend. It has ticked up since the middle of the fourth quarter, but anything below 50 is a contraction reading. Mario Draghi, President of the ECB, is still confident that Europe will see growth in the second half, but it’s still too early to tell.

markit eurozone pmi gdp

If I could sum up the current market story in one sentence, it would be: “Too late to buy and too early to sell”. Energy was the big winner on today’s market tape as natural gas officially formed a double bottom and charged towards $4. Many of the gassy producers were printing mid-single digit returns today with breakout charts galore. Some of those names show promise on the charts. If I had money burning in my pockets, that’s where I’d be focusing my attention. Until I get some sell signals in my indicators and until we get a majority of stocks forming topping formations, the market can stay overbought. Maybe longer than anyone would have thought.

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About Ryan Puplava CMT