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Near-Term Trading Top Is Due for a Pullback Into Mid/Late October


Fund managers feeling performance pressure played catch-up and kept the market high. Now this week or next, they will watch the market reverse but can likely count on a year-end rally.

From Tom Lauricella in the Wall Street Journal (9/7/12):

It was the rally that left many fund managers behind. Stocks jumped nearly 10% over the summer, defying the expectations of many hedge – and mutual – fund managers who had bet on a decline. They saw a multitude of headwinds from Europe's woes to the slowing US economy and sluggish corporate earnings.

Now, those defensive fund managers are facing what's known in Wall Street lingo as the "pain trade"; having to buy stocks just to avoid being left in the dust.

The longer stocks hold the summer's gains, the more deeply the pain could be felt, forcing fund managers to start buying. That, in turn, could give stock prices another leg up and potentially generate a virtuous circle for the stock market and even more pain for those on the defensive.

"A lot of people were waiting for the next big selloff and it never materialized," said Dan Greenhaus, chief global strategist at brokerage firm BTIG. "There's going to be that pressure to try and play catch-up and not just merely play along but to gain some outperformance."

In last week's verbal strategy comments, I suggested participants study the chart pattern of the S&P 500 (SPX) and then think about what it would feel like if you were an underinvested portfolio manager (or PM), or even worse a hedge fund that is massively short of stocks betting on a big decline. The concurrent performance anxiety would be legend because not only would you have performance risk, but also bonus risk and ultimately job risk.

Accordingly, I have been opining that stocks were likely going break above the April highs (1420 – 1422) and then trade higher toward the 1450 – 1477 zone driven by what Dan Greenhaus said: "that pressure to try and play catch-up and not just merely play along but to gain some outperformance."

Of course, that performance pressure is magnified with end of the third quarter "report cards" due for PMs, followed by fiscal year-end, as many PMs close their books at the end of October.

Last week, the performance pressure increased noticeably when the SPX and the Nasdaq Composite Index both traded out to new reaction highs. In the Nasdaq's case, it "tagged" its highest level since 2000!

While that is good news, it should be noted that the financials are still 58.8% from their all-time highs, telecom services are 54.8% from their all-time highs, and technology is 49.6% away. Still, the SPX has registered a topside breakout from one of the longest, and tightest, trading ranges in decades.

Interestingly, in each of the four other instances this pattern has occurred, the SPX has rallied an additional 2% - 5%. In the current case that would imply a rally to somewhere between 1445 and 1473, which is consistent with my longstanding target zone of 1450 – 1477. It would also be consistent with the historical chart pattern for the SPX in an election year that my friends at the invaluable Bespoke organization identified months ago (see chart below).

Accordingly, I would look for some kind of trading "top" this week and next followed by a decline into mid/late October that should sink the "footings" for the fabled year-end rally.
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No positions in stocks mentioned.
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