Thursday, July 23, 2009
Stocks have been moving straight up, ignoring all the conventional overbought technical indicators. Investors are anxious to buy into even the slightest decline. And when that decline turns into a rally, the fear of missing out on another upside explosion coaxes more money in from the sidelines, propelling stocks even higher.
Ultimately, though, stocks will correct and the market will have a chance to work off the overbought conditions. It's the old "rubber band" analogy. Stocks can only stretch so far in one direction before they snap back into a more neutral trading range.
The market makes extreme moves like this maybe two or three times each year. Sometimes the rubber band is stretched to the downside, like it was in March, and stocks react by putting on a dramatic rally. And sometimes the rubber band is stretched to the upside, as it is now. This should lead to a sharp pullback.
Every once in a while, though, the rubber band breaks. Stocks roll right through the technical indicators and continue their path higher (or lower). This happens about once or twice a decade. The most notable example is the Internet stock "melt-up" in late 1999.
I don't think we're in a melt-up environment. Traders are too skittish. They lack the conviction necessary for a long-term, sustainable, gravity-defying push higher. But I'm putting this idea out here, just to be sure you're aware of the possibility – as remote as it may be.
More than likely, the current environment is one where stock prices travel higher long enough to whip the short sellers, suck money in from the sidelines, and lull the masses into a greater sense of complacency. After those conditions are met, stocks can start the next leg down in the great bear market. Here's an updated look at the big picture...
This is a monthly chart of the S&P 500 plotted against its 20-month exponential moving average (EMA). The 20-month EMA defines bull and bear markets. When stocks trade above the line, they're in a bull market. When the index is below the line, the bear is in charge.
The first leg of the bear market bottomed in March. It was an extreme move, and the rubber band was stretched much too far to the downside. We knew we were due for one heck of a "snap back" rally, and we got a 30%+ move higher in just a few weeks.
Stocks are no longer oversold on this long-term chart. The index is close enough to its 20-month EMA to meet the requirements of a snap-back rally. While the S&P 500 could rally another 100 points before turning back lower, my shorter-term charts suggest stocks could roll over sooner rather than later.
So both the long-term and short-term charts have a bearish tilt to them. The problem now exists in the intermediate term.
Two months ago, my two favorite intermediate-term indicators – the Nasdaq Summation Index (NASI) and the NYSE Summation Index (NYSI) – flashed sell signals. Today, they're saying it's time to buy.
There's no easy trade to make in the midst of conflicting indicators. The nature and extent of any short-term pullback will tell us a lot about where stocks are headed over the next few weeks. But it is simply too dangerous to buy anything in an extended market. And it's too dangerous to put on new short positions until price action confirms a short-term correction.
Best regards and good trading,
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