Bulls Still In Control Despite Cross-Currents

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Clif Droke
Summary

Immediate-term trend still bullish heading into 2018.

Investor sentiment is becoming frothy, but internal momentum should compensate for this.

Weight of evidence favors higher stock prices in the coming months.

The last three months of 2017 were beneficial for stock investors. Volatility was minimal and equity prices advanced steadily during most of the quarter. By the end of December, the S&P 500 had gained a respectable 6% in Q4 alone. After such a solid performance, however, many believe the market is overstretched and vulnerable to a correction in the coming weeks. In this commentary we'll examine this possibility in light of the evidence provided by the market's internal condition.

Although the market posted a winning December, stocks finished the last trading day of 2017 sharply lower. The S&P 500 (SPX) settled the holiday-abbreviated week down 0.4%, mainly due to a sell-off in the last 30 minutes of trading on Friday, Dec. 29.

Despite Friday's losses, the major indices registered gains for 2017 ranging from 13.1% (Russell 2000) to 28.2% (NASDAQ) and 19.4% for the SPX, before dividends. Friday's losses were mainly relegated to the health care (-0.7%), financial (-0.7%), consumer discretionary (-0.7%), and information technology (-0.6%) sectors, all of which were among the market's best-performing sectors for 2017. There was no apparent catalyst for the selling, which was most likely related to profit-taking. It may also have been a move taken by investors to secure long-term capital gains after deferring them at the end of 2017 as the tax bill was being worked out.

NYSE Composite Index

Source: www.BigCharts.com

Heading into the New Year the stock market remains on a positive track despite some short-term cross-currents. Five of the six major indices finished the last week of 2017 above the rising 15-day moving average, which means the immediate-term (1-4 week) trend is still technically up as measured by our trend indicator. Only the NASDAQ 100 Index (NDX) was below the 15-day MA for the week.

The NYSE 52-week new highs-lows indicator also remains in a decisively rising trend, which means the market's internal condition is still very constructive. This indicator has been the single most important one for confirming the strength and persistence of the bull market for most of this year. As long as it continues rising I recommend that we treat it as a confirmation that the buyers have control over the market.

Chart created by Clif Droke

There are some internal inconsistencies, however. For instance, investor sentiment is starting to become a bit frothy after several weeks of fairly healthy readings. The latest AAII investor sentiment poll released on Dec. 28 revealed the highest percentage of bulls in over two years (53%). Even the previous week's bullish percentage was uncomfortably high at 50%. Historically, anything above 50% - especially if it persists for more than a couple of weeks - can mark the start of a short-term topping process for stocks. By contrast, the latest bearish sentiment reading was 21% which is also quite low by historical standards.

Chart created by Clif Droke

I would also point out that the short-term directional component of the NYSE HI-Lo Momentum (HILMO) indicator has begun to diverge lower in recent days. This indicator reflects the 4-week rate of change in the new highs-new lows and is the indicator I rely on to project the market's near-term path of least resistance. The graph shown below features this indicator as the blue line. What this indicator is telling me is that the market could encounter some broad market turbulence in the very near term, something we'll need to watch for as we enter January.

Chart created by Clif Droke

The internal trend component of the HILMO index (green line) is also diverging sharply lower against the upward path of stock prices. However, the short-term momentum bias component (red line) is moving sharply higher in contrast to the other two components. Taking all three components together, my conclusion is that there are enough internal cross-currents to guarantee at least some choppiness in the coming weeks, but not enough to warrant a bearish position in the stock market. More importantly, the cumulative new highs-lows indicator discussed above is decisively telling us to maintain a bullish posture for now despite the internal cross-currents in the HILMO index.

I would also point out that the dominant intermediate-term internal momentum components of HILMO shown in the following graph is still in a strongly rising trend. That's another indication that the buyers continue to enjoy an advantage over the sellers, thus giving us another reason for continuing to lean bullish in spite of some short-term technical divergences.

Chart created by Clif Droke

One of the most important confirmations that the stock market remains in strong hands is found in the following graph of the Financial Conditions Index (FCI). This is my own measure of the current health of the financial sector and it encompasses the broadest measure of the U.S. stock market including the S&P 500, the PHLX/KBW Bank Index (BKX), the NYSE Securities Broker/Dealer Index (XBD), and the BofA Merrill Lynch U.S. Credit Spread Index . Here's what the indicator looks like as of the end of December.

Chart created by Clif Droke

As you can see, the FCI is currently at a yearly high and doesn't suggest any underlying deterioration of financial conditions. If the stock market were setting up for a sizable decline in early 2018, we should see signs of weakness in the FCI. Instead we see the opposite as the financial sector remains a picture of health and soundness entering the New Year.

There are enough negative indications right now to give us pause for thought and suggest that perhaps a short-term period of increased turbulence may be imminent for equities. By the same token, the NYSE stock market's path of least resistance remains up in spite of any increased choppiness stocks may encounter in the early part of 2018.

In light of the above mentioned considerations, this would be a good opportunity for investors to cut loose any serious laggards from investment portfolios while concentrating on relative strength and momentum winners among individual stocks. Based on the internal cross-currents discussed here, we may soon encounter another period of narrowing performance in the market where stock selection becomes paramount. The bulls, however, still technically enjoy the advantage entering the new year and should maintain their control over the broad equity market in the coming months as the bull market pushes ahead.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.