Are the Markets Headed for a Correction?

Includes: DIA, QQQ, SPY
by: Babak

The stock market has been in rally mode since the start of September. Since then the S&P 500 has gained 13%, very close to the ~15% it gained from the early February 2010 lows until mid-April 2010. With that has come a few breadth signals that the rally is getting tired and may need to rest or retrace before continuing.

Earlier I mentioned the overbought breadth reading from the percentage of issues in the S&P 500 trading above their 50 day moving average. This was the highest since April’s top. That measure has backed away slightly from the peak (93%) and it now at 89%.

But other measures of market internals are very elevated. For example, the daily advance decline statistics are very high and the McClellan Summation index, which is based on that raw data is reaching levels we haven’t seen since early May 2010, as the market was rolling over:

Click to see a larger chart in a new tab:
McClellan summation index Oct 2010

Usually when the McClellan Summation index peaks around this level, the stock market either corrects or treads water to digest its gains. The exception is when we have a very high velocity momentum market coming out of an incredibly oversold bear market condition. We saw this twice in the past 10 years: first in 2003 and then in 2009. I’ve drawn circles around those instances to mark them better. With those exceptions, however, the McClellan Summation index is a good measure of how ‘tired’ breadth is.

By the way, I use the Nasdaq McClellan Summation index instead of the NYSE variation due to the pollution of non-operating company issues trading on the big board which skew the breadth data significantly.

Click to see a larger chart in a new tab:
S&P500 index 2001 to 2010 Oct 2010
The other breadth measure I refer to repeatedly is the analysis of the number of new highs relative to new lows. The High-Low index is basically a ratio of the number of new 52 week highs divided by the number of new 52 week lows added to the new highs. Since it can be rather jittery, I’ve smoothed it with a 10 day (or 2 trading week) moving average. You can see the same two periods of extreme momentum when the needle got stuck almost consistently to 90-100%. Excluding those, a reading this high corresponds to a market top:

Click to see a larger chart in a new tab:
S&P500 high low index Oct 2010

Fibonacci Target
Moving away from market internals, we can take a look at the charts based on simple resistance and support. With such a rally in place, it is normal for the market to consolidate the gains before moving forward, especially with the April highs so close and acting as resistance.

fibonacci retracement Oct 2010

A 61.8% Fibonacci retracement between the low in early July (1010.91) to the ‘top’ from Monday (1185.53) gives a target area at 1118. This also dovetails nicely with the previous resistance which pushed back the S&P 500 in mid June and early August. So as a previous resistance level, this is a natural support area for the market to retest.