Bob Palmerton's  Instablog

As the equity markets reach for new highs, support for the uptrend is reinforced by a series of market indicators that remain firmly bullish. Baseline Analytics categorizes these indicators into three broad components:

1. Trend and Sentiment

2. Breadth and Internal Strength

3. Economic Indicators

Here is a visual display of how these indicators are performing today.

Trend and Sentiment. The steep uptrend in the S&P500, as seen in the chart below, is steeper for my liking and would suggest a pause at some point relatively soon. Based on the strength of the uptrend, however, a pause is more likely to be seen as a trading range market or consolidation of recent gains, rather than an outright correction. Sharp trendlines like that shown on the S&P500 chart below ultimately get broken. As for sentiment indicators, we look for extremes in VIX (such as a reading of 12 or below) and the Put/Call Ratio (such as a reading of 0.60 and below) to suggest a possible trend shift to the downside for equities. We do not see that in today's indicators, as both remain neutral.

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Breadth and Internal Strength. Indicators such as the NYSE Advance/Decline Ratio, New Highs vs. New Lows and the NYSE Summation Index all point solidly in the bullish direction with no divergences from equity market performance. The Summation Index is a breadth indicator based on Net Advances (advancing issues less declining issues). We look for the 400-level to mark the dividing line between an uptrend and a downtrend (the reading closed on Tuesday at 1218, nearly a new high).

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Finally, Baseline Analytics reviews a series of economic and industry sector indicators. LQD vs. IEF is a ratio of corporate vs. US Government bonds. As the ratio climbs, the equity markets tend to move to the upside. Copper vs. US Bonds prices, as well as the S&P500 relative to bonds, reflect economic strength and risk appetite, as rising trends tend to coincide with higher equity prices. Copper has struggled for a while; despite the pickup in housing starts, mediocre GDP growth as well as a slowdown in China GDP and manufacturing growth rates may be factors weighing on this indicator. This represents a negative divergence from the equity markets. Other indicators of economic strength and reinforcement of the "risk on" trade include the relative outperformance of Small Caps vs. Large Caps (see our recent Blog on the topic), as well as outperformance of discretionary stocks vs. staples and defensive equities.

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The strength of these market and economic indicators lend support to the bullish case. As most of these indicators push to new highs, caution is warranted, and a pause in the uptrend would be viewed as a welcome respite and an opportunity to join in on the rally and a favorable entry point.

- Baseline Analytics

One of the indicators favored by Baseline Analytics is the Growth vs. Value Ratio. This is measured by taking the Russell 2000 Growth Index (RUO) divided by the Russell 2000 Value Index (RUJ). To measure trend, we plot this ratio against its 50-day exponential moving average. See the chart below:

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As you will note, the Growth/Value Ratio, denoted by the solid blue line, tends to outperform during uptrends in the S&P500. Conversely, the Growth/Value Ratio underperforms during S&P500 downtrends, as value tends to be favored. Growth stocks tend to outperform during bullish enthusiasm, presiding during the "risk-on" trade.

In April, you can see that the ratio edged above its moving average (very slightly) and appears to be forming a respectable basing pattern. A climbing ratio will be supportive of a continued advance in the market indices. Keep a watch on this activity.

- Baseline Analytics

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

As veteran investor and money manager Bob Farrell has noted, the market cannot continue to rally with just a few large-caps (generals) leading the way. Small and mid-caps (the troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.

As seen in the chart below, small caps relative performance vs. large caps peaked in May, 2011. Since then, performance has lagged, and has taken a pointed hit as recently as March, 2013. Studies have also noted that small-cap firms tend to outperform large-caps over the years subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag. This would appear consistent with the slowing down of economic growth after the sharp run-up of GDP following the 2009 trough. The lagging small-caps may be a warning sign that a peak in the economic cycle is emerging.

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Also noted in the chart above, there has been a lag of about 2 years between the peak in small-caps and the peak in the S&P500. If this relationship holds, it would suggest a stock market peak in the relative near-term.

Taking into consideration the slowing economic momentum and the historic technical relative performance of small-caps vs. large-caps, a potential warning sign emerges for the stock market in general.

- Baseline Analytics