Shallow 5% Pullback Led to Short Covering

Yesterday’s bounce occurred after a relatively shallow 5.00 % pullback in the S&P 500 from its recent peak.  So far this move appears to be more short covering driven than a new wave of institutional buying.

Several things we noticed of late and also in yesterday’s activity were as follows”  The recent corrective wave saw Small Caps take it on the chin much harder than large caps.  For example at Wednesday’s lows the S&P 600(SML)a proxy for small caps was down close to 9.00 % whereas the S&P 100(OEX) a proxy for large stocks was a more modest 4.5 %.

This suggests to us there is a performance shift and that going forward large cap will favor small caps.

Other things to note:

* Internals on the NASDAQ behind yesterday’s point move were average not stellar (though the NYSE numbers were much better than NASDAQ)

* The banks stocks which have severely underperformed the market of late (down over 13.00 % at Wednesday low vs. only 5.24 % for the S&P 500) continued that under performance yesterday registering a return that trailed the SP 500 by 0.50 basis points.

* New Highs have contracted significantly over the past two weeks as new lows have crept up. The recent wide spread between new highs versus new lows is now at parity./blockquote>

Thus in the near run momentum underneath the surface of the market is weakening, suggesting we may need to correct a bit deeper than Wednesday’s low before we reach a more firm trading low.

Longer term liquidity still remains strong (AAII Allocations to Equities remains 5.00 % below its 21 year mean suggesting investors still under invested in equities.  Meanwhile sentiment continues to be neutral (AAII Bulls only at 35 % yesterday) suggesting that the correction should be fairly limited in duration and depth.

We believe this recent correction should go a bit lower and then at those lower levels (Possibly S&P 1,000) the combination of strong liquidity and increasing bearishness should provide another move in the index to new 2009 highs.

However even with that said we think it will be a more selective (thinner) rally where large cap stocks lead and small caps do not participate as much.

We will be sending a note out later this morning with some other indicators of interest that support the aforementioned thesis.

Note the contraction in the new 52 week high – 52 week low line of late back below the 0 line. Suggest we will have a bit deeper correction this time.

52 week highs

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