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The S & P 500 has the potential to move to 1000 over the short term. And while that would be a positive for those holding stocks, there are signs that even such a rally should be questioned and be looked upon with caution.
Just as we are supposed to be headed for the summer doldrums, it looks as if the market is trying to set up for one more move higher. The telltale sign is the lack of volatility, we've seen in the last few days as the market has consolidated. But consolidations are basically creating an environment like a spring that is coiling, saving energy for its next move. Oh, there are lots of reasons why this rally should end, starting with the fact that it’s getting a little old in the tooth having started in early March. And there are still lots of bears, often including this scribe, that are still wondering how much longer before reality sets it.
At the same time, there are many signs that this market is closer to some sort of meaningful correction than to another 20% rally to the up side. According to Mark Hulbert, the action in the most speculative stock markets in the world is so far ahead of normal that it's a sign of big trouble ahead. In his latest column, Hulbert noted "if you're not worried about the rapid return since then of irrational exuberance, you're not paying attention." Hulbert, quoting the Wall Street Journal, cited several examples of investor overconfidence, such as the small cap stock revival in Europe where that sector is up 21% for the year. Another one is the performance of so called "frontier markets," described as 'so "small, illiquid or otherwise inaccessible" that they are not even considered "emerging" -- countries such as Croatia, Nigeria and Sri Lanka. MSCI's Frontier Markets Index is up 51% since the March 9 low.'
Hulbert also notes that newsletter writer optimism is on the rise, writing: "The editor of the average short-timing market timing newsletter, for example, is a lot more bullish now than he was at the early March low. In fact, his recommended equity exposure has grown by some 60 percentage points since then -- which is more than double the average increase in the first three months of past bull markets."
What we're noting is that there are two clear things happening. It’s hard to argue with the fact that the market remains resilient and that it’s not really showing signs of topping out. Even after a bad day or two, key support levels, such as the 20 and 50-day moving averages are still acting as buffers from selling. This is the bullish case.
Chart Courtesy of StockCharts.com
Yet, as the market climbs, (see S & P chart 500 above) there are signs that not all is at it should be. Perhaps the most bothersome is the fact that as the market climbs there are lots of technical divergences that are appearing. Most of them are in commonly used technical oscillators such as MACD, RSI, and Stochastics, the realm of chartists, professional and otherwise. These are all showing that the market’s momentum is ebbing, and that as stock prices have risen lately, volume is receding, leading to the conclusion that there is less conviction among buyers than just a few weeks ago.
Note that the S & P 500's high in May had a higher peak in RSI (upper oscillator) and MACD (lower oscillators) than the peak in both oscillators with the most recent high in the index. Also note that volume (lower portion of chart) has been falling as prices have been rising of late.
That means that the market is vulnerable to sellers. That, of course sets up a dangerous situation. Simply put, as the summer develops, external events, political, having to do with terrorism, or even a bad set of earnings or economic reports could give holders of stocks that excuse they need to become sellers of stocks. And as anyone who’s done any trading knows, when everyone heads for the exits at the same time, markets tend to drop precipitously.
What are the odds of something like that happening this summer? Probably much higher than anyone would like to think, as the potential hot spots are numerous on all sides of the market. What’s our biggest worry? Aside from a rogue nation or terrorist group doing something nasty, Washington is clearly in the lead as the top fear factory. With the White House hell bent on rewriting history by the end of the year, and Congress more than willing to help, investors should be wary of domestic policy and its implications, which is why the bond market has been steadily selling off and interest rates are on the rise.
And there is more. There are two important bond auctions coming up. One is for ten year notes and the other is for 30 year bonds. Oil and commodities are back on the rise. And geopolitical tensions remain high with Iran's election looming and the Arab-Israeli problems showing signs of coming to a boil at some point in the not too distant future.
Conclusion
The stock market is on the rise. But the rally is not as strong as it was three months ago. That means that the odds of an important pullback in prices are also on the rise.
The question now is more of when we see some kind of retrenchment than if we will actually see one.
History shows that big bull runs such as the one we have just had could go on for some time, especially if you are just watching the indexes.
So, how do you play this? If you've got open long positions, you stick with them. If you're going to buy stocks, buy those that are showing strong relative strength, and buy small positions with a short term viewpoint.
And keep this old adage in mind. As any sports coach would tell us: play your game. If you are good with health care or energy stocks, trade those over stocks in sectors with which you are less familiar. Look for opportunities that are low hanging fruit. Keep things simple. And follow your trading plan, including the use of sell stops and other hedges. More than anything, though, don’t take your eyes off of that ball. That pitch from Washington is coming at the speed of light, and it’s a combination slider, fastball, and curve, all at once.
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