Market trends positive, but questions linger

Last week’s resumption of the market advance pushed the S&P 500 Index, Dow Jones Industrial Average, and the NASDAQ Composite Index to their best levels since March 2009 with the Value Index rallying to a new all-time high. The S&P was up 1.3% on the week with the Dow ahead 1.4%, the NASDAQ up 1.4%, and the Value Line ahead 2.1%. All four finished toward weekly highs.

Clearly, the market’s ability to keep moving upward is a reflection of underlying buying power. Simply put, it only takes a few more buyers than sellers to make prices keep rising. It is that tone of a “few more.” however, that has bothered us for weeks, given the fact Cumulative Volume in none of the key indexes has yet to better its late April 2010 highs (see S&P CV chart below).

And while we know we are starting to sound like a broken record on this score, the fact is that this developing divergence between market prices and CV is a classic bearish disparity that could ultimately come back to haunt pricing. To use a military metaphor, imagine lines of supply that have been progressively overextended. History has many examples of this sort of vulnerability, but probably the most memorable was the campaign begun by Hitler’s Wehrmacht in June 1941 against the Soviet Union. Simply put, the German troops got way ahead of their supplies and support, a weakness which ultimately resulted in their defeat when superior Russian forces overwhelmed them.

Click chart to enlarge

The same sort of vulnerability can develop in the stock market. Prices continue to rally, but behind the scenes volume diminishes as upside momentum fails. Ultimately the scales tip and the market turns lower.

What do we look for next? In a nutshell, the rally since the July 2010 lows has been orderly. Following those July lows and the subsequent uptrend, there was a month of weakness from early November until early December and then more buying followed. At this juncture, however, the second leg of the rally from the December lows is nearly equal to the rally from the July lows to early November. The two rallies are almost perfectly symmetrical in terms of time spent and distance traveled. Unfortunately, the market rarely affords investors perfect symmetry. So we would expect a pullback to begin somewhere in this environment, given the fact that making money has begun to get a bit too easy of late. For the past several months all investors have had to do is buy and hold. As we learned following the October 2007 highs, such a strategy was not the best choice.

It is unlikely, however, that the market will sustain a longer-term downtrend until there is a pullback and then a retracement of the losses to determine whether or not new highs can be created. Currently the S&P could decline about 7% to the bottom of the trailing 10-week price channel and statistical support without terminating the intermediate-term uptrend begun back in July. Weakness back toward the 1250-1240 area could set the index up for a short-term low and a near-term “oversold” condition. Thereafter, however, prices would have to rally back to and above the recently made highs to re-assert the uptrend or an intermediate-term peak would probably be signaled with more concerted weakness thereafter. Then we would have to take a harder look at major cycle price channel support which is currently about 17% below current levels back near 1100 in the S&P. That would be the level which would have to hold to keep the major uptrend intact.

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