Market Update: Seven-Month Rally Is Getting Tired

During the past week the stock market has shown numerous signs that the seven-month rally, which has carried shares to not only deeply overbought territory but to their highest valuations in years as well, is getting tired.

Heading into trading this week, the S&P 500 was 20 percent above its 200-day moving average. This is a rather rare occurrence. For instance, even at the height of the tech bubble in 2000 we didn’t reach such an overextended point. In fact, during the Post War period the only occasions we moved up so far, so fast was briefly in 1975, 1982 and again in 1983.

Stocks promptly fell sharply after reaching that lofty level in 1975, by 1982 and 1983 shares traded sideways for a time, consolidating their gains. But what was striking about these past occurrences was that valuations were so much lower than they are today, with trailing P/Es in the in 10 to 13 region, as compared to an off the scale reading of more than 140 for the S&P today.

Even using the S&P Industrials as a benchmark (thereby excluding the troubled financials) the P/E right now is 32.5. Likewise, even using the most optimistic estimate of forward earnings, stocks are quite dear. Using other benchmarks, like dividend yields or price to sales, the bull case for stocks here falls short.

Looking at the stock charts also sends up a couple of caution flags. The S&P 500 Depositary Receipts (SPY) ETF is a proxy for small investors wanting exposure to the broad market. That ETF filled a gap in its price chart dating back to 10/10/08. When studying stock charts it pays to mind the gaps. Once filled, trend reversals typically occur.

The other glaring indication of what may be coming down the pike can be seen in the action in the Dow Transports. Long ago, Charles Dow popularized his Dow Theory, which in essence views the market as healthy when both manufacturers (the Industrials) and shippers (the Transports) are rising in tandem. Divergences between the two should set off alarm bells. So while the Industrials have managed to claw their way back above 10,000, the Transports have tried and failed to surpass their mid September highs, tracing out a double top formation in the process.

Finally, we’re seeing the beginnings of dramatic underperformance of small caps relative to blue chips. The little guys had been leading the charge by a fairly wide margin heading into last week’s trading. But by week’s end, the Russell 2000 Index of small fry was off nearly 2.5 percent, whereas the venerable Dow Industrials were off by less than a quarter of a percentage point. Small stocks led on the way up and they’ll likely spearhead a major decline, so their recent showing of the small fry is cause for concern.

The U.S. dollar, which had become deeply oversold, has staged a modest recovery in the last few days. That has put pressure on commodities, including oil and gold. This could run a bit further, but we see it as a buying opportunity.

Comments

[dhjoe:]

Curious that your article sounds bearish on stocks, but ends with a note that pullback would be good entry point for oil and gold. It looks to me at the moment nothing is decoupled. If dollar continues to rally re-flation trade assets will all be hit - i.e. Stocks, gold, oil, commodities, carry trade currencies. If dollar continues to decline these assets will go up in value, they are all joined at the hip.

Oct 28 04:59 PM

[Dave Wrixon:]

Tired? Tired is when you need a short break before continuing your journey.

I think the term you are looking for is Sclerotic,

Oct 28 06:44 PM

[untrusting ...:]

Exactly right. The problem with the dollar in the ST is that large dollar devaluation and the reverse currency appreciation in other countries is causing them problems. Thus they clearly have been putting pressure on the US to do something. Even some interventions by some of the Asian countries. That plus the reported 97% short postion in the dollar, makes it very vunerable to a dollar reversal which will be fueled by short covering. Always a potentially ST explosive situation when lots of short covering may be triggered.


On Oct 28 04:59 PM dhjoe wrote:

> Curious that your article sounds bearish on stocks, but ends with
> a note that pullback would be good entry point for oil and gold.
> It looks to me at the moment nothing is decoupled. If dollar continues
> to rally re-flation trade assets will all be hit - i.e. Stocks, gold,
> oil, commodities, carry trade currencies. If dollar continues to
> decline these assets will go up in value, they are all joined at
> the hip.

Oct 28 11:16 PM