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Stocks Remain Vulnerable to Violent Correction

Jan. 18, 2011 5:08 PM ETSPY, DIA, QQQ2 Comments
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The stock market rally from early September remains extremely overextended on a short-term basis with the S&P 500 index now up more than 23% during the past 4.5 months without undergoing a meaningful correction.

We are experiencing typical market behavior for the middle stage of a secular bear market as heightened volatility continues to drive violent moves higher and lower.

When a speculative advance gains this much momentum, it becomes impossible to predict when the inevitable correction will occur with any useful degree of statistical confidence. However, careful monitoring of technical, internal and sentiment data will tell you when the uptrend is weakening and thus becoming vulnerable to a sudden reversal, and we have been witnessing meaningful deterioration during the past two months. Our Cyclical Trend Score (CTS) has been negatively diverging from the S&P 500 index since the brief consolidation period in November.

Notice how the CTS has rebounded only slightly off of the mid December low as the S&P 500 has rocketed up to a new long-term high. The CTS is a measure of underlying cyclical trend health, and this negative divergence indicates that the rally is losing strength. You can also see this developing weakness manifested in broad market breadth and volume data. While price action has moved up to a new long-term high, breadth and volume have been unable to confirm this breakout via long-term breakouts of their own.

These confirmation failures in both breadth and volume are additional negative divergences that signal developing weakness in the rally. Excessive bullish sentiment also suggests that the uptrend is vulnerable to an abrupt reversal as our Sentiment Score continues to hold near the lowest level since late 2007.

Looking ahead, a break below uptrend support currently at 1,257 on the S&P 500 would be the first sign of short-term technical weakness. From a long-term perspective, the cyclical uptrend from early 2009 remains in control. However, the character of the next correction should provide a great deal of clarity with respect to future direction. If the next meaningful downtrend holds above congestion support in the 1,180 area before returning to recent highs, a subsequent breakout and continuation of the cyclical uptrend will become likely. On the other hand, if the next correction ultimately breaks below congestion support at the 1,150 level, the long-term topping scenario will reassert itself.

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

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