Can the Market Strength Continue?

 |  Includes: IWM, QQQ, SPY
by: optionMONSTER

By Bryan McCormick

As a tumultuous week in markets comes to an end, each index has pushed close to multi-year highs or to major year-to-date resistance. Earlier concerns about China tightening, the Koreas, and the ongoing debt crisis in Europe failed to quell bullish enthusiasm. But what are economic indicators telling us about the future?

The sentiment picture by one measure--Investors Intelligence U.S. Advisors Sentiment, which comes out on a weekly basis--shows that we are inching ever closer to an extreme. For the last several weeks running, bullish sentiment has hit over the 55 area. By the company's own measure, this level of bullishness reflects an overheating of sentiment that could make a market vulnerable to a selloff.

The theory behind sentiment measures is that if advisers are already strongly bullish, they may have become fully invested and therefore have left little cash to come in to support prices. At extremes, this indicator can be useful if imprecise, as it is one piece of evidence that suggests that a run-up can be getting over-extended.

This gauge works the same way in reverse at lows, when bullish readings can get into the 20s. For now, however, the high bullish reading is a background environmental factor suggesting that the markets may be getting ahead of themselves.

5-Year SPX, 200-Week Moving Average

IndexUniverse, which is a free service, published a note this week on the very large inflow into ETFs in November. In this case, the money was directed at U.S. equities, which saw inflows of more than $6 billion.

Flows of course are pretty good indicators of where prices are going to go: If people are aggressive buyers, any price can be supported for a time. However, the proviso is that when flows too reach extremes, they can be a give-up indicator.

The theory behind that measure is that if flows reach extremes, there will simply be less money available in the future to support the current market direction. This works at market lows too when redemptions from funds can reach extremes. Again, flows aren't precise indicators, but they do give us factor No. 2 in building a case that the macro environment may be getting a little heady.

Then we have the technical conditions of the markets themselves. I am not a huge fan of "overbought" or "oversold" conditions used in isolation, but they are worth noting in a broader context.

Overbought conditions in a bull market can be bullish, just as oversold in a bear market can be perfectly normal. Right now we are overbought in all time frames, even extending out to a monthly duration.

That doesn't happen very often, given how long it can take that indicator to move. Again, not a slam dunk and not a worry unless the indicator begins to turn down from those highs, indicating a reversal of momentum and a corrective phase.

The final element is that the Russell 2000, Nasdaq 100, and S&P 500 are all near or slightly above their year-to-date highs. (The five-year chart above shows the 200-week moving average for the SPX in purple.)

Taking into account all the other factors cited in this post, this is at minimum a warning that the current market strength may not be sustainable. It is ironic that it is precisely because conditions seem so good that we may have a problem in the next few weeks.

Extreme conditions can persist for some time. But it may be getting very late for the bulls, who have had it their way since August.

Disclosure: No positions