Stock Market Warning Signs Become More Pronounced

Includes: DIA, QQQ, SPY
by: Erik McCurdy

The S&P 500 index closed moderately lower Wednesday, retreating from recent highs of both the rally from early September and the cyclical uptrend from early 2009.

Click to enlarge

We have been monitoring deterioration in numerous market internals since November, and the observed warning signals have intensified during recent weeks as evidenced by the negative divergence that has developed between our Cyclical Trend Score (CTS) and the S&P 500 index.

Click to enlarge

click on charts to enlarge

Notice how the CTS has trended lower since early December while stocks have moved up to a marginal new high. This divergence suggests that the rally is losing internal strength. You can also see the deterioration manifested in broad market breadth and volume summation indices.

Click to enlarge
Click to enlarge

Like the CTS, market breadth and volume have trended sharply lower during this last move higher for stocks. Market psychology also remains at bullish extremes as reflected by our sentiment score holding well into sell territory.

Click to enlarge

Fund manager John Hussman of Hussman Funds has also been monitoring his own set of warning signs during the past several weeks, and he noted the past performance of similar market environments in his latest weekly commentary.

In recent weeks, the U.S. stock market has been characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile to stocks. Last week, the situation became much more pointed. Past instances have been associated with such uniformly negative outcomes that the current situation has to be accompanied by the word "warning."

The following set of conditions is one way to capture the basic "overvalued, overbought, overbullish, rising-yields" syndrome:

1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller P/E greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27% (Investor's Intelligence)

The historical instances corresponding to these conditions are as follows:

December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)
August - September 1987 (followed by a 34% plunge over the following 3 months)
July 1998 (followed abruptly by an 18% loss over the following 3 months)
July 1999 (followed by a 12% market loss over the next 3 months)
January 2000 (followed by a spike 10% loss over the next 6 weeks)
March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002)
July 2007 (followed by a 57% market plunge over the following 21 months)
January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks)
April 2010 (followed by a 17% market loss over the following 3 months)
December 2010 (followed by ?)

As always, we deal with possibilities and probabilities, never certainties. However, the compelling nature of the deterioration that is occurring beneath the surface as stocks test long-term highs warrants extreme caution at the moment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.