Pre-Holiday Market Outlook: Mixed Bag of Signals, More Risk Than Reward

Includes: DIA, QQQ, SPY
by: Wall Street Sector Selector

by John Nyaradi

Rudolph was well into bringing the “Santa Rally” to town when this week he suddenly ran into the ominous sounding “Hindenburg Omen.” Beyond that, economic news was mostly positive while markets remain overbought, breadth is dwindling and upward momentum has stalled heading into the lightly traded Christmas week.

Looking at My Screens

As I mentioned, momentum is dwindling as the indexes stall near highs for the year. Bullish sentiment remains at high extremes typically associated with market tops and preceding significant declines.

Also, last week markets generated a confirmed “Hindenburg Omen” that is a fairly reliable forecaster for impending markets declines.

There are lots of good articles about the Hindenburg Omen but the salient facts from are these:

  • There is a more than 75% probability of a decline of 5% or more after a confirmed Hindenburg Omen.
  • Larger selloffs have occured roughly 40% of the time after an omen while the probability of a major crash is approximately 25%.
  • A Hindenburg Omen has been generated before every major stock market decline since 1985.
  • Over the past 25 years, it has a greater than 90% accuracy rate.

While I’m not a follower of the Hindenburg Omen and don’t base trading decisions upon its occurences, I believe its statistical performance merits attention, particularly when combined with other technical indicators currently flashing caution.

Interestingly, the last Hindenburg Omen occured in August and received wide attention in both the blogosphere and mainstream media. In contrast, the current signal has gone largely unnoticed which is fascinating from a contrarian point of view. As we all know, when everyone in the market expects one thing to happen (prices to rise) usually the opposite occurs.

The View from 35,000 Feet

This was a largely bullish week for economic reports as Housing Starts, Retail Sales, Empire State Manufacturing, Industrial Production, Initial Unemployment Claims, Housing Starts and Leading Economic Indicators all came in on the positive side of the ledger.

In the minus column, rising interest rates continued troubling markets along with the ongoing problems in Europe, particularly Moody’s downgrade of Ireland by five steps.

But propping markets up, the Fed continued its bond buying program and Congress passed the tax cut extension/stimulus bill that President Obama promptly signed. That is a classic case of kicking the can down the road but that is a subject for another day.

What It All Means

Technically, the markets are showing substantial deterioration while economic reports continue to show improvement so we have a mixed bag of signals.

Investor bullishness is reaching nearly manic highs while seasonal factors favor higher prices. All along the way, the Fed continues its asset buying program to prop up asset prices while Europe continues to bubble in the background.

Rudolph has run into the Hindenburg and it will be interesting to see if Rudolph and Santa can complete their appointed rounds this Christmas season.

It seems a logical conclusion that at the current juncture there is more risk than reward in the market over the next few weeks and into the early days of 2011.

At Wall Street Sector Selector we have switched to the “Yellow Flag” mode, expecting choppy and possibly lower prices ahead.

The Week Ahead

It’s a short holiday week and so volume is likely to be light. However, there are a few significant economic reports regarding U.S. economic output, the housing market, employment and personal spending that could be market movers as we head toward the Holidays.

Wednesday: Mortgage Applications, Q3 GDP 3rd Estimate, November Existing Home Sales

Thursday: Initial and continuing unemployment claims, November Personal Income, November Personal Spending, November Durable Goods, December University of Michigan Sentiment, November New Home Sales

Sector Spotlight:

Winners: Biotech (NASDAQ:IBB), Chile (NYSEARCA:ECH), Sweden (NYSEARCA:EWD)

Losers: Turkey (NYSEARCA:TUR), Spain (NYSEARCA:EWP), China (NASDAQ:FCHI)

I would like to wish each of you a very Happy Holiday and hope you’ll be able to make great memories with family and friends. My family will be together around the fireplace and doing some skiing on Mt. Bachelor, enjoying our family traditions and taking a few moments to rest at the end of what has been a tumultuous year.