Seeking Alpha
Portfolio strategy
Profile| Send Message|
( followers)  

The relatively modest pullback in the S&P 500 index ($SPX) from a high of 1422 to the recent low of 1357 is not enough, in and of itself, to suggest the formation of a top in the stock market.

In this essay I will describe where I believe the U.S. stock market stands from a technical perspective and offer some potential scenarios going forward.

Technical Outlook And Potential Scenarios

1. Non-confirmation signals. There are a few preliminary signs that a top may be forming in the stock market. The first, and by far the most important, is the massive number of non-confirmation signals in economically sensitive sectors and in international equity markets. Cyclical sectors and economically sensitive sectors such as basic materials (XLB) have been sending clear non-confirmation signals. Furthermore, a variety of key international markets have been flashing very loud non-confirmations. The most important are those in Spain and Italy, which is where the epicenter of current global financial risks lie. China's equity market is indicating a strong non-confirmation signal. With the lone exception of Germany, every single major market in Europe and Asia is either below or is testing the 200 moving average. All of these are clear signals that the U.S. market rally is premised on narrow domestic considerations (technical and fundamental) and is likely not sustainable.

2. Change of character. Another sign of a potential top is that in the last few trading sessions, the market has been revealing a "change in character." First, for the only time since the rally began, the market has several times closed at or near the bottom of its intraday trading range. This is a sign of flagging demand. Second, the gap up on Monday the 16th of April followed by a quick move into negative territory is entirely out of character for this advance. Finally, the strong negative divergence in Apple (AAPL) and Google's (GOOG) performance on April 16th also comprises a very noticeable change in character.

3. Sentiment. Bullish sentiment and complacency reached extremes during the advance as reflected in various measures such as sentiment surveys (e.g. AAII), put/call ratios and the VIX. What is interesting is that these sentiment indicators have recently reverted very strongly. Some may interpret this as a bullish sign. I believe such an interpretation is a mistake. A severe and sudden reversal of sentiment indicates shifting opinions and intentions and does not reflect an actual reduction of equity exposure. It will take many days and even weeks for investors to reduce equity exposure to align with their increasingly cautious outlook. This suggests that there is considerable supply that will be coming onto the market in coming weeks.

4. Retest of the high is likely. The advance from December 19, 2011, to April 2, 2012, occurred without any significant pullback. Many investors cannot psychologically bring themselves to purchase stocks during such a steep and steady advance. Most investors feel more comfortable "buying a dip." Many investors that did not participate in the rally will likely feel "relieved" at the opportunity to "buy the dip." Thus, I expect that there is still significant residual pent-up demand for equities that will likely result in one or more re-tests of the 1,422 high.

5. Distribution. The most likely manner in which a top will proceed is with a "distribution" in which the market enters into a fairly wide horizontal trading range. This distribution will largely be an exchange of shares between the relieved "dip buyers" and the increasingly skittish holders of stock.

6. Increased volatility. An eventual breakdown from the horizontal trading range is likely to be signaled by a dramatic increase in volatility. I would expect intraday trading ranges to widen to 2.0%-plus before a definitive move down commences in earnest.

7. First test. The first critical test that will provide a sign regarding whether the market is forming a top is whether the market breaks the recent low of 1357 on the S&P 500 (GSPC). A break of this low in the context of a failure to rally to the high of 1422 would be a sign that the market is losing its upward impetus.

8. Key support levels. A break of 1357 is likely to set up a test of the region around 1345 (+-5). A lower end of a new trading range is likely to be established somewhere between 1345 and 1292. 1,292 is a key technical level because it coincides with horizontal support and the 10% "correction" threshold. 1292 also happens to be an important Fibonacci retracement level (I do not believe in the efficacy of Fibonacci retracement levels, but many technical traders do).

9. Coincidence of fundamental headwinds. The possible formation of a top is coinciding with the emergence of a plethora of potential fundamental headwinds. Elections in France and Greece; potential European bank downgrades (Moody's); critical Spanish sovereign debt offerings; 1Q European GDP releases; Irish fiscal compact referendum; slowing U.S. earnings growth; the "sell in May" lore. Various other headwinds converging in the mid-Mid April to mid-May time frame could be named.

Conclusion

The stock market rally since October 2011 has mainly been technically driven. The fundamental foundation for the U.S. stock market rally since October of 2012 has been exceptionally weak. For example, presumed fundamental improvements in Europe have proved utterly illusory. Corporate profit margins and expected U.S. earnings growth have been contracting very significantly. Macroeconomic risks in Europe, China, Japan and elsewhere have actually been rising during the rally. U.S. economic growth is tepid and the economy remains vulnerable.

Rallies that are primarily driven by technical factors, by definition, will not be sustained for very long. This is because technical cycles are mean-reverting by definition and are essentially zero-sum.

In the absence of a solid fundamental foundation, the question at hand is when the technical inflection point will be reached for U.S. indices and index ETFs (SPY), (DIA), (QQQ). It would be premature to point to any definitive technical signals of a stock market top at the present time. However, there are various telling preliminary indicia.

The technical character of the rally since October has been such that I expect U.S. stocks will soon enter into a "distribution" phase rather than a swift reversal. If so, I expect the market to retest the 1422 highs and perhaps even make marginal new highs within the context of such a distribution. I expect that this distribution phase will set the stage for a new down movement that will ultimately produce a test of the 950-1,020 level on the S&P 500.

Source: Signs Of A Stock Market Top?