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Will the Stock Market Go Up or Down?

SPX TechnicalsDouble Click Image for Full Sized View

I thought a quick update of the things I am seeing in the market would be of interest to everyone.  In short, I think we are due for a bit of a pullback based upon how the market internals are reacting to recent events.

Above is a graph of the S&P 500 Index along with several indicators that I follow.

The top panel is the Relative Strength Index.  This indicator measures the momentum in the market based upon price change and the speed of those changes.  Whenever it shows a reading above the 80 level, this generally means that the index has moved up too fast giving us an overbought situation.  Generally, this is corrected by a drop in prices of a few to several percentage points in the index.  You can see that I have circled the overbought reading in red.

What I see here is a warning sign that the market could pull back sometime over the next few days to consolidate the gains it has chalked up.

The panel below that is the S&P 500 Index itself.  In this case, I am using the candlestick version of the graph because it gives me an idea of what happened on each day based upon the color (black is up, red is down) and size (trading range for the day).  You will also notice a light beige color under the index – this is an area graph of the S&P 500 Equal Weight Index, a totally separate measurement of the same 500 companies with the difference being that the S&P 500 Index is weighted based upon the size of the company (Apple is the biggest company in the index by Market Capitalization, so it makes up the largest percentage of the index).  The Equal Weight Index simply takes all 500 companies and weights them at 0.2% of the total.

I have drawn two red boxes and two red lines on this graph.  The red box on the left shows you the last time that there was a divergence between the two indices, with the Equal Weigh falling in value while the S&P 500 kept moving higher for a few days.  You can see that after a few days, the S&P 500 Index fell as well.  The box on the right shows you the market action of the past few days.  You can see by the two red lines I drew that the S&P 500 continues higher (except for two small down days yesterday and today) when the Equal Weight has already moved lower.

What I see here is a warning sign that the market is ready to pull back similar to the way it did in the red box on the left.

Further down, you see I have a red oval drawn over the Full Stochastics indicator.  This is again a momentum indicator showing an overbought reading.  This supports the earlier momentum indicator, telling us to expect a bit of a pullback in coming days.

The bottom three indicators are all breadth indicators for the market – basically, they tell us how individual stocks are reacting within the market as a whole.

The uppermost of the bottom three is the Advance / Decline line indicator I use.  You see that the blue shorter term 10 day moving average line has been falling the past several days indicating that on a daily basis there are a greater number of companies falling in price.  It has just crossed over the red intermediate term 30 day moving average line which is holding steady.

What this tells me is that the intermediate term picture is still healthy, but near term we are in for a price pull back.

The middle of the three panels is the McClellan Oscillator – a breadth measure of the net advances and declines – you can see that it I have drawn a red down trending line.  This represents a divergence from the S&P 500 which has continued higher as breadth has weakened.  You can see that it is now below zero, telling us that there are now more stocks falling in price than gaining in price.  Additionally, you can see the purple arrow I drew showing the days that they indicator was above the 50 level.  Historically, readings above 50 cannot be sustained and a drop in both net advances and declines as well as prices is ahead.

What this tells me is that we should see the index fall in price soon.

The bottom of the three panels is the McClellan Summation Index.  This is a derivation of a derivation – it basically takes the readings of the McClellan Oscillator and adds them together.  That give us an intermediate term indicator, which currently shows that the intermediate term outlook for the market is fine.

In addition, we skipped several panels in the middle of the graph that show us cash flow is still moving into the market and that the intermediate term picture is good as of now.

In recent weeks/months, I’ve discussed the divergence between corporate earnings and stock prices.  Corporate earnings are predicted to be down 15% in 2015 (and that forecast is proving correct) whereas the stock market – until the August swoon – was moving ever higher and achieving more unrealistic valuations.  A lot of the overvalued situation corrected itself in August, but since end of September, the market has moved back toward the old highs.

I advised you that as we approached the 2050 area of the S&P 500, we would employ risk management and start raising cash for the inevitable pull back in prices to sustainable levels.  When the McClellan Oscillator moved over 50, we began to book profits on many of the stocks we bought during the August correction.  We have also been sellers of higher beta stocks (ones that are inherently more volatile than the overall market), and we have included sales of some companies whose performance has been weak due to sales or foreign exchange issues so that when the fall occurs, we hold the strongest companies possible so that we outperform the index.

Risk management is a critical part of active portfolio management and we utilize both fundamental analysis and technical market indicators to help us achieve this goal and to keep everyone happy.