As would be expected, economic reports are becoming more and more positive as the economic recovery continues.
Many analysts are touting those reports as a reason not to be concerned about the market’s overbought condition and the very high level of bullish investor sentiment, both at levels often seen at rally tops.
However, the S&P 500 is overbought above its 200-day m.a. to a degree that even in a strong bull market usually results in a pullback to at least retest the support at the m.a. before the upside resumes.
At this point a normal pullback just to retest the support at the m.a. would be a 10% decline for the S&P 500, 12% for the even more overbought Nasdaq, and 14% for the Russell 2000. It would carry the market back to its level of last May.
That kind of give-back would be well worth avoiding. So whether continuing strong economic reports can prevent a double-digit pullback is an important question right now.
History tells us that good times and positive economic reports are not always a reason to ignore risk when other conditions indicate that risk is unusually high. The economy usually looks good, sometimes great (think 2000 and 2007) at market tops, and terrible at market bottoms. The market often climbs a wall of worry, shaking off bad news when it’s in rally mode, and is often not able to rally in spite of good news when other factors have it running into profit taking and selling pressures.
We have to realize that the market has already factored in a substantial economic recovery with its big bull market last year off the March, 2009 bottom, and in its big rally off the July low this year.
I was reminded of that by the market’s muted response to the super strong ADP employment report and the ISM service sector report on Wednesday.
The ADP report was that a huge 297,000 new jobs were created in the private sector in December, triple the consensus estimate, and the largest monthly increase since ADP began keeping its numbers in 2000. And it was also reported that the ISM service sector Index grew in December at its fastest pace in four years.
It was surprising that the Dow could eke out only a 31 point (0.3%) gain, the NYSE Composite only a 0.2% gain, in reaction to that kind of news.
Perhaps it will make up for it after Friday morning’s Labor Department employment report.
We’re squeezing as much as we can out of the rally as long as it lasts, as well as making profits from the more impressive Japanese market, and from the rally in the U.S. dollar, and downside positions against plunging Treasury bonds.
However, if you read my forecast for 2011 last week you know we’re expecting a sell signal and correction this month and running into February before the market recovers into a positive year.
We don’t have a sell signal yet, and may not get one. But I’m not expecting that positive economic reports at this point will overcome the overbought condition and prevent a sell-off. So we’re watching our technical indicators closely for a potential sell signal, and investors need to be cautious, not a popular thought when investor sentiment is so bullish and confident.
