Technicals Bode Market Conflicts AheadApr 15th, 2010 | By Rob | Category: DS Feature, Market Synopsis, U.S.
U.S. equities have vigorously rallied for the past six weeks to gain +20%, bringing the S&P 500 just above 1200, as Q1 2010 earnings hit the tape. Alcoa’s (AA) profit of -$0.20/share missed the street’s $0.10 outlook on Monday, but Intel (INTC) sealed a Tuesday win for the bulls as profit beat the $0.38 estimate by +$0.05. JP Morgan’s Jamie Diamon cited increased consumer strength in it’s Wednesday earnings beat, while March’s Retail Sales numbers confirmed strength with a 1.6% monthly gain. On the shoulders of the recent tear in stock prices, the week’s outlook on remaining earnings from Google (GOOG), Bank of America (BAC) and General Electric (GE) is zealous to say the least. The prophetic rally in equities confirmed this trend of sustained macro and micro strength by rallying into and through the news, but there are reasons to question the tone from here.
In short, the charts are begging for a pullback in every equity index from the S&P 500 to the German DAX, but earnings and economic indicators are giving no reason to sell. Most analysts agree that the good news is mostly baked in to the run up in stocks, but sellers have left the building and buyers keep coming out of the woodwork.
The saying goes, “all good things do come to an end,” but this time it’s difficult to find a bear argument anywhere. We have been negative on the market for most of this year due to a series of long term issues facing the global market (e.g. rising interest rates, sovereign defaults, and asset bubbles in China), but this orgy will continue until the data gives it a reason to stop.
Here we’d like to focus on a few indicators related to the S&P 500 that will show just how over-bought markets are, and why investors should be taking profits at these levels. (See chart below…)
First, let’s begin with the RSI, or Relative Strength Index, which acts as a price momentum metric, and is marked by the blue circle at the top right of the chart. If the RSI is above 70 or below 30, the underlying instrument is said to be “overbought” or “oversold”. The RSI is currently at 78.29, well above the “overbought” mark, and is effectively higher than at any point over the last year. What’s more interesting, is that when you compare the absolute value of the RSI gap above and below the 70 and 30 levels, the RSI is farthest from 50 during any point in the sell-off as well. The most “oversold” day of the market crash in October 2008, according to the RSI, was on October 10, 2008, where the RSI closed at 22.88, or 7.18 below the crucial level of 30.
As we all know October 10 was not the end of the selling during the bear trend, so the 78.29 RSI on Wednesday may not spell out a peak in this bull cycle, but it puts the stock rally in perspective. It is important to note that the RSI met similarly high levels in January and November of 2004, during the last recession’s recovery. Still, the S&P 500 recovered the %20 from 1000 to 1200 over a period of 18 months in 2004-2005, rather than the recent 9 month recovery over the same span.
Turning to the Bollinger Bands, represented by the green lines above and below the price chart, we can again see a technical signal of an over-excited market. The Bollinger Bands, developed by John Bollinger, show the range of two standard deviations above and below the 20 day simple moving average of the underlying security. Traditionally prices move within these bands and many times change directions when they near the two standard deviation border in either positive or negative territory. Recently the SPX has risen precipitously along the lines of the upper band and on Wednesday closed outside the upper band. While this can occur and not signal a major trend shift, as in mid February on the downside, it is a mark of extreme irrationality for a close to occur outside the bands at the end of a long and sustained trend.
Saving the simplest observation for last, the price of the SPX above it’s respective 50 and 200 day simple moving averages (SMA) is unsustainable and congruent with other short term peaks during the current bull cycle, and until the pullback in February, the S&P 500 had closed below it’s 50 day moving average only briefly before charging higher. These two facts combined tell us that the rally has shown weakness when negative news presents itself, and that during periods of overwhelming optimism the prices have generally moved above their moving averages by magnitudes similar to now. The SPX is trading 6.5% above it’s 50 day SMA and 12.9% above the 200 day SMA, and has traded above these magnitudes above trend for nearly 30 days.
All three of these technical observations are evidence of strength in the S&P 500 and large cap U.S. stocks, but should also beckon reason for concern. Short term developments may yet sustain the unprecedented rally in equities, yet the realization of rising interest rates, further uncertainty via European insolvency, and outlandish imballances in Chinese fiscal policy will serve as negative catalysts to sentiment in the U.S. and abroad. Take this chance to survey the risks facing your portfolio as markets forge ahead towards thinner ice and greater imbalance.