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Since late November, the S&P 500 has been marching higher in a steady uptrend. Over this time period, the index is sporting an impressive 22% gain. More recently, the late April and early May period experienced an explosive move higher with the index climbing 9% in the month. In these two articles, I gave my reasons for bullishness entering this time period.

As greed and complacency began to take over and with rumors of Fed "tapering" on the horizon, the stock market got choppier with certain sectors selling off hard, especially more interest rate dependent ones. Subsequently, the overall market fell and at Thursday's lows had basically wiped out half the gains from the rally with the S&P 500 down 5% from its peak. In this article, I gave my reasons for not buying into the weakness in late May.

Although the market did significantly weaken from its highs, it has bounced back strong in the last two days. Of course, a pertinent matter is whether this is the end of the correction and a resumption of the uptrend that has characterized much of 2013. I want to lay out my reasons for continuing to be patient and examine some evidence pointing to a range bound market in the near term. Finally, I will describe what needs to happen for me to change my stance.

Below we can see the impressive performance of the S&P 500, as well as the recent slump and strong move higher:

Click to enlarge images.

Caution for Bulls

One remarkable feature of this sell-off was the steady selling pressure:

This chart shows the intraday action of the advance-decline line, one measure of market breadth. The key takeaway from this chart is that even on up days, there was net selling as many of the stocks that opened positive finished lower. Bulls want to see the opposite -- signs of net buying in individual names on down days. For me to believe that this recent rally is anything more than a technical, oversold bounce, I want to see signs of accumulation amidst weakness.

Another important factor is the performance of oversold sectors. Typically, a new leg up in a bull market requires a tremendous amount of liquidity. This liquidity takes the bulk of stocks and sectors higher, especially oversold sectors as the shorts are squeezed. This dynamic was present in the April-May rally. Currently, I am watching some of the hardest hit sectors, such as high-yield bonds and emerging markets.

An ETF for the emerging markets is the iShares MSCI Emerging Markets Indx (NYSEARCA:EEM) and for high-yield bonds is iShares iBoxx $ High Yid Corp Bond (NYSEARCA:HYG).

Another driving force of the selling has been the unwinding of the yen carry trade. One of the biggest trades this year has been borrowing in yen to buy stocks across the world. As the yen has strengthened, this has caused selling pressure in stocks. Below, we can see a chart of the yen vs. the S&P 500 to see the correlation:

Caution for Bears

For bears looking for a breakdown, the action of the past two days is an apt reminder that there remains a persistent bid under the market. The market seems to have digested the "tapering" talk and in some ways the meme that "bad news is good" has returned. Although I discussed earlier the distribution during this recent phase, stepping back there is no doubt that breadth and price both remain in uptrends.

Furthermore, there is an important argument going on between those that say the rise in interest rates is due more to economic improvement rather than the Fed decreasing its purchase of bonds. I don't agree with this argument, but there are some pieces of evidence supporting this notion:

Both of these measures have held up well during this period of weakness in the general markets. When traders are optimistic about future economic conditions, cyclicals and small-cap stocks tend to outperform. As long as these are holding up well, bears should not fall in love with the downside.

Earlier, I discussed the lack of overwhelming buying interest in the high-yield bonds and emerging markets, which undercut a notion of a resumption of the uptrend. However, bears should note that the Japanese stock market -- which has been annihilated over the past couple of weeks -- has participated in the up move. Furthermore, commodities are also showing some relative strength after being one of the weakest sectors for much of 2013.

The ETF for the Japanese stock market is the iShares MSCI Japan Index (NYSEARCA:EWJ), for the S&P 500 it is the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), and for the small caps index it is the iShares Russell 2000 (NYSEARCA:IWM).


My analysis toward the general market stems from studying market conditions and then formulating a strategy that is appropriate for such conditions. Certain strategies that work splendidly at times can also be devastating at the wrong time. A recent example is chasing oversold sectors with high short interest such as shipping and solar stocks which worked great for a while, but in recent weeks have given back a large chunk of gains.

I think rangebound markets are the toughest and many swing traders end up getting chopped up as they chase breakouts and breakdowns. For example, I'm sure many bears were getting excited as we approached 1600 on the S&P 500 this week.

In order to become bullish, I want to see signs of accumulation and outperformance from high beta indexes. If these conditions materialize, then I will switch back to "buy the dip" mode. On an individual stock level, I want to see stocks breaking out and holding new highs. Of course, the drawback is that I will be buying stocks at higher levels than now and certainly the lows of last week, exposing me to larger drawdowns if I am wrong. However, I think the trade off is worth it given the current uncertainty.

While price action firmly favors the bulls, some factors are more favorable for the bears hoping for a breakdown. To them, I would advise patience. If the market is going to break down, there will be plenty of time and opportunities to take advantage.

I remain neutral and completely open to both possibilities. Within the range, I will look for opportunities on both sides of the market. In this climate, stock picking is especially rewarded. During strong uptrends, anyone long stocks tends to do well while during down trending markets, the majority of stocks are punished.

We had a rangebound market from March to late April. During this period, sectors such as materials, industrials, and basic materials corrected. On the other hand, consumer staples, utilities, and consumer discretionary stocks were trending up steadily. This type of environment is frustrating for both bulls and bears looking for large directional moves, but can be rewarding for traders who play the range and/or stock pickers who can manage risk.

Source: S&P 500: Is The Correction Over?