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Stock Market Unlikely to Leap Higher Just Yet


We need to spend a few more sessions working off the overbought condition.


However, despite this improving earnings backdrop investors continue to shun stocks, worried about Euroquake, our dysfunctional Congress, Middles East unrest, China's slowing economy, etc. Meanwhile, many pundits have heightened those worries by talking about the weakness of the Dow Jones Transportation Average (INDEXDJX:DJT), as well as a Dow Theory "sell signal." The last time this same crowd trumpeted a Dow Theory "sell signal" was back in May when the Industrials fell below their mid-April lows confirmed by a similar move from the Trannies. At the time I was adamant that according to my work there had been NO Dow Theory "sell signal," which is the same stance I am taking now. In my opinion, the Trannies were affected last week by a downgrade of the railroad stocks from a major brokerage firm, a depression in the coal industry (less rail traffic), and the weather (Hurricane Isaac). Regrettably, it will be a few months before we see if that is the correct "call."

Certainly many of the sectors, as well as indices, think that is the correct "call" because the biotechnology, consumer discretionary, consumer staples, and health-care sectors have traded to new all-time highs. Ditto, the S&P Equal Weighted Index (INDEXNYSEGIS:SPXEW), the S&P 400 Mid Cap Index (INDEXSP:SP400), the S&P 600 Small Cap Index (INDEXSP:SP600), and the Value Line (VALU) Arithmetic Index have traded to new all-time highs. If past is prelude it should not be too long before the S&P 500 (INDEXSP:.INX) does the same thing. Of course this differs with the election year chart I have been using this year, which telegraphed a peak for the SPX at the beginning of September follow by a pullback into mid/late-October and then a rally to higher highs. And, it looked like we were going to get a continuation of that election year trading pattern until the Federal Reserve announced QEternity. On that announcement the 98% correlation with the typical election year trading pattern completely fell apart as the INDU vaulted 206 points. The Dow Delight, however, left ALL of the macro sectors I monitor severely overbought; as well, the NYSE McClellan Oscillator was about as overbought as it ever gets.

Accordingly, in last Monday's missive I wrote:

An overbought condition can be resolved in one of two ways. First, the SPX can pause and move sideways while the overbought condition is remedied. Second, the SPX can pull back to what had previously been an overhead resistance level, but now becomes a support zone. In the current case that would entail a pullback to 1400 – 1422 for the SPX. Importantly, when the stock market generates an overbought condition of last week's magnitude it suggests there is more strength coming in the future after the overbought condition is rectified. Indeed, uptrends typically do not end on really high overbought readings from the NYSE McClellan Oscillator. So, while two weeks ago I thought we were reaching for a short-term "trading top," I believe that following some kind of pullback, or sideways movement, the major market indices will go higher.
No positions in stocks mentioned.
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