Technical Overview: Strength Beneath Overbought Surface

The S&P 500 index is closed the year just 1.9 points off its 52 week high. This year the S&P 500 index rose 12.7% and rallied 23% from its low in July. This has brought the index right into a strong resistance area:

From a short term viewpoint equities are on a precarious peak right now. Sentiment has been building into a crescendo of euphoria. Positive seasonality both from the end of year (or Santa Claus rally) as well as the presidential cycle has provided strong support for a sustained rally. But that is all about to end. As well, sentiment extremes take a little longer to wreak havoc within a bull market. But they do eventually kick in and cause prices to weaken.

In a recent interview with Bob Pisani, Paul Desmond of Lowry Research said that they are expecting a correction of up to 10% in January 2011: “We’re expecting a fairly stiff correction, somewhere in the seven to ten percent range, some time in January”. But Lowry still believes that the maket is in a primary uptrend.

One of the reasons is that breadth indicators such as the percent of issues trading above a certain moving average are all pointing to a strong market. Desmond notes that the percentage of issues trading above their 20 day, 50 day and 150 day moving averages are all above 80%. Here is a chart showing the percentage of S&P 500 issues trading above their 200 day moving averages:

I showed this chart a few weeks ago (Technical Overview). Since then, the percentage of S&P 500 issues trading above their long term trend has continued to rise and reached 89%. I can’t help but compare the uptrend of this breadth indicator now with the downtrend that it displayed in 2007. As the market indexes were pushing ahead, less and less issues were trading above their long term trend. That is, fewer and fewer components had to rise to lift the whole index. Eventually, this leadership thinned out so much that the market collapsed. We are seeing the opposite of that with a plebian rally that encompasses the vast majority of issues in the S&P 500 index.

Lowry primarily relies on their indicators of demand and supply. In this previous post you can see a previous chart showing the progress of Lowry’s two proprietary indicators of demand and supply. As I mentioned recently, in a rare display of strength, those two lines have now crossed. Desmond says, “If you go back to the 78-year history of Lowry’s data, you will never find a major market top having been formed while the Selling Pressure Index is dropping to new lows.”

Another major sign of positive breadth is the operating company only cumulative advance decline line. This is an indicator that weeds out all of the ETFs, CEFs, municipal bond funds and bond issues trading on the NYSE to get at the true picture of breadth in equities. According to Desmond, the cumulative total of advancing issues minus declining issues has reached the highest level in over a decade!

We can simulate quite accurately the operating company only cumulative advance decline line that Lowry and NDR painstakingly puts together by looking at the S&P 500’s own cumulative breadth indicator:

This advance decline line confirms the strength that Paul Desmond mentions. While the S&P 500 itself has yet to approach the highs it reached in late 2007, this breadth indicator surpassed it some months ago and has gone on to muli-year highs. This makes Desmond believe that “the market may be headed for all-time highs, above the 2007 highs.”

So be careful out there if you are still hanging on to any long positions. The mental image that comes to mind is that of Wile E. Coyote running in place with nothing but a puff of air holding him up momentarily… before he plummets painfully to the ravine waiting below.

I wish you all a safe, prosperous and wonderful Happy New Year!

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10 Responses to Technical Overview: Strength Beneath Overbought Surface

  1. Bo says:

    Happy New Year ,Babak !

  2. Onlooker says:

    Wow, that second to last paragraph is jarringly bearish as opposed to the main thesis of the entire article. I assume you’re just referring to a possible short term sharp correction, right?

    And even given that, if your overall, longer term, bullish thesis is correct then those with longs are probably better off just holding, as most will just sell in fear in a nasty correction, only to watch the market take off again without them. Or even better, trimming back a bit to soften the blow and improve their basis by buying the dip. Easier said than done, for most.

    Once again, it just really seemed like the summary paragraph didn’t fit the overall article. That paragraph makes it sound like a new bear is around the corner, but that’s not the conclusion to be reached when reading the rest of your article.

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  4. Babak says:

    Onlooker, perhaps I was a bit melodramatic. But there is a difference between short term and long term and I hope that it was clear when you read the complete message. As a trader, my approach is usually to try to catch each wave. Also, I take the market as it is and analyse it one step at a time. We have no idea if next month, after a potential correction, things will look this good in the long term.

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  7. Tiho says:

    The stock market is overdue for a correction without a doubt. Instead of trying to short the market, an investor might want to buy some US Dollars or even play the long side of the Bond market in the short term.

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