Technical Overview: An Excuse To Sell

Here is a quick recap of the technical situation for the market. I get the sense that we are finally arriving at the long awaited correction. The sentiment surveys suggested it should have arrived weeks ago as did multiple gurus like DeMark.

The tone of the market is changing as the indexes start to wobble at dizzying heights. Whereas before bad news was ignored, it is now an excuse to sell.

Dow Theory Divergence
One of the most visible divergences is the one presented by the Dow Transportation index compared to the Dow Industrial index. According to the Dow Theory, the rise of the Dow Jones Industrial index must be confirmed by the Transports. That hasn’t been the case recently:

While the Dow Jones Industrial index went straight up during the year, the Transports topped out in January and corrected more severely. They managed to regain their high recently but have now fallen below the January correction low. Meanwhile the Dow Industrial Average is still above that level.

New Highs Lagging
Since the start of this cyclical bull market in March 2009, the number of Nasdaq new highs has managed to keep pace with the market’s rise. I use the Nasdaq new 52 week high figures instead of the NYSE to avoid the effect of non-common stock issues.

But recently, the number of new highs has stalled, even as the market itself has forged ahead. This is a dangerous adventure because while it may last a little while, an index can’t sustain a prolonged rally without new highs.

Out of Breadth
Another way to look at this is the percentage of S&P 500 index components that are trading above their own 50 day moving average. We’d expect this to expand with the market and to contract with market declines.

Again, we see the same type of divergence: the market has gone ahead of the underlying forces that support it. That is to say, if the components of the S&P 500 index can not sustain themselves above their 50 day moving average, how are they to propel the market higher? They can’t. And in that situation, the market rises on fumes as fewer and fewer individual issues support its higher valuation.

Leaderless Market
Yet another way to see this same characteristic is to look at the ‘generals’ that have been the point of the spear for the bull market. Recently, they have faltered and are no longer leading. The names should be familiar to everyone: Google (GOOG), Amazon (AMZN), Baidu (BIDU), Netflix (NFLX), Apple (AAPL), Priceline (PCLN), etc.

As well, as Michael Kahn points out in yesterday’s column, many of the Dow Jones Industrial stocks are falling from breakouts. Take a look at the charts of Wal-Mart (WMT), Hewlett-Packard (HPQ), Boeing (BA), and Intel (INTC) This technical failure or head-fake is a sign of a change in market behavior.

OEX Open Interest
If you’ve been keeping up with the weekly sentiment overview, then you know that the ‘smart money’ continues to funnel more and more into puts. They started to build up this position weeks ago when everything was just peachy and the S&P 500 index was still going just in one direction (up!). As of today, the short term moving average of the put call open interest ratio for the S&P 100 index is up to 1.65 (from 1.61 last Friday). The last time it was this high was July 2007 – just as the market was teetering on a major top.

Long Term Outlook
So with these setbacks, is it time to bail on the bull market completely? I’m not yet convinced of that. The long term outlook continues to remain robust. The cumulative breadth of the S&P 500 index is showing a slight positive divergence. And the bullish percent index is not providing a reason to interpret this as a major top.

My hunch is that we are close to it but that this is the first of several corrections before the actual top arrives. Perhaps it is the recency effect talking but I draw a parallel to the 2007 market top which took several months to carve out. The way that the market and sentiment reacts to a real correction will provide further insight into this. A 10% correction will take us back down to the breakout line in late 2010. That, in turn will have now become a support line and will be expected to provide a floor.