Digestion or Indigestion?

After a healthy run up in the indices, the markets have been churning, unable to make much upwards progress. This lack of progress has occurred despite a parade of very encouraging economic numbers. Much of the good news has already been accounted for in the year’s heady gains. Is this consolidation a mere digestion process, the pause that refreshes prior to the next big leg up? Or, is it part of a topping process that leads to a sharp correction?

There are 3 factors we watch closely as an early warning of the potential breakdown in market internals:

1) Trendline Support: This has been a momentum driven market, and is likely to continue that way until the 2003 up trend is broken. The trend remains up as long as the charts of the SPX, NDX, and Dow, are all above the bottom of their channels and above their 50 and 200 day, upward sloping moving averages. A serious breach ends the up trend.

2) Leadership sectors: An early indicator of a potential breakdown will be if the leaders of the rally start to roll over: Watch the Bank Index (BKX), Semiconductors (SMH), Internets (HHH), and Cyclicals (CYC). Note that the Biotechs (BBH) already have penetrated their up trend line.

3) Advance-Decline Line: The internals of this rally have been healthy, and while some mild deterioration is to be expected, it bears watching. A significant drop would cause some consternation amongst holders of long positions.

4) Sentiment (AAII): Has been excessively optimistic since mid-Summer. As we noted earlier,
Bullish sentiment can reach extreme levels – and stay that way – for months at a time. A little less complacency would be a healthy thing. Perhaps a mild breakdown in the A/D line would cause just enough worry to alleviate the excessive optimism we see.

After the big move up since March, the Bulls may be starting to tire. For the rally to remain healthy, a little “digestion” is necessary. With the market at the upper half of its up channel, and moving towards support at the lower half, the trend remains in effect. Over the short term, some “backing and filling” would work off some of the overbought condition. That would also be a healthy thing.

As long as trend lines are not penetrated, and internals only suffer mild decay, the overall Bullish momentum will remain. Conservative traders should tighten up their stops. Aggressive traders can use the pullback towards the bottom of the trend channel to add new positions. Patience is usually rewarded.

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  1. Leonard commented on Nov 11

    A note on the Fed model. A table I made from 1987 to 2003 showed the median earnings yield was 75% of the 10 yr bond yield, which indicated that was “normal.” Going back to 1900-1950 however, bond yields were greater than stock yields. That indicates yield and risk (volatility) are joined at the hip.

    In the first half of the twentieth century people perceived stocks as riskier than bonds and they were priced accordingly. In the second half though, investors believed bonds were risker than stocks. Probably due to the threat of inflation.

    That seems to be the current thinking: stocks are the best bets in the long run and therefore deserve the smallest risk premium, i.e. largest p/e. The VIX almost serves as a proxy for earnings yield.

    Until the mind set changes stocks will retain their premium.

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