Market Poised for a Transitory Rally

Includes: XLF
by: Cam Hui, CFA

After six straight weeks of losses, the stock market is poised for a "transitory" rally. Investor sentiment has turned decidedly bearish, which is contrarian bullish. Most overbought / oversold indicators are well into oversold territory.

NYSE New Highs - New Lows
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My favorite intermediate term overbought / oversold indicator is also signaling that the market is poised for a countertrend rally lasting 1-3 weeks.

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Here is another warning for the bears. We are heading into option expiry week this week, which historically has had a bullish bias.

No all-clear for bulls
Nevertheless, the intermediate and longer term pictures don't look very positive. Measures of risk appetite have already turned down, and the risk-off trade is in a well-defined downtrend.

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Long term headwinds
In addition, Lakshman Achuthan of economic forecasting firm ECRI, which has correctly called previous recessions, stated that the U.S. economy is on the verge of a sustained slowdown.

More worrisome is the technical position of the financials. I wrote previously that the BKX was on the verge of a relative breakdown. Such events have been associated with high levels of systemic risk in the financial system (i.e. Russia Crisis and Subprime Crisis). Well, the BKX definitively broke down last week, though it rallied on Friday to test the bottom of the relative support zone.

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This relative breakdown is confirmed by the performance of the broader financials against the market.

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Bottom line: The equity market appears to be setting up for a decline of unknown proportions. The decline could be just a plain vanilla 10-15% correction. However, there is a definite possibility that it could be something more serious, such as a repeat of the Lehman Crisis of 2008.

The markets are poised for a tactical rally. My inner investor is extremely cautious and inclined to be very defensive. On the other hand, my inner trader is telling me-- despite the technical breakdowns-- don't start new short positions at this time.