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Quietly, a Top Seems to Be Forming


Consider these indicators.

For many months, bearish commentators have been speculating about a top and "the next leg down." After getting thoroughly embarrassed by the market, many of these pundits are now quiet. Funny, because for the first time since the rally began in March of 2009, there are real indications of a topping process underway. Consider the following indicators:

1. Earnings growth expectations are strong, currently standing at 62.1%. However, for the first time since the start of the rally in March of 2009, the second derivative of aggregate earnings estimates are trending down rather than up. After rising consistently during October and November, estimates for earnings growth dropped considerably in December and now stand below where expectations were in early October.

2. Financials and cyclicals have been leaders in earnings growth and price appreciation since the March 2009 lows. And currently, their expected earning growth accounts for a disproportionate amount of overall earnings growth for the S&P 500. However, there are signs that analysts may have overshot estimates in these sectors. Yesterday's Alcoa (AA) disappointment and recent downwards revisions in banks, if symptomatic, could take the legs out from under key market leadership.

3. Volatility as measured by the VIX at 17.55% is well below the 20-year average of 20.3%. Does this make sense? Is risk really lower today than it's been on average in the past 20 years?

4. As another indicator of growing complacency regarding risk, investors may be interested to note that corporate bond spreads have contracted to levels well below that which prevailed during early 2008. For example, the spread between Baa corporate bonds is at the lowest levels since July of 2007. Yes, you read correctly. Now, does that make sense?

In sum, earnings expectations appear to have fully caught up with improving reality, and expectations may have even overshot a bit. Furthermore, perceptions of risk have become complacent. These are indicators of a topping process -- not necessarily of a top, per se.

I'll repeat my prediction outlined in my article Are We Headed For A Range-Bound Market?, the market is likely to settle into a sideways consolidation or trading range for several months, rather than follow a "W" pattern that would lead to a retest previous lows.

There's still far too much cash on the sidelines, particularly amongst individuals. And anxiety over having missed out on the 2009 rally is simple human nature. When the market pulls back, it will feel like an "opportunity" to many that have "missed out" on the rally. Dip-buying by investors with this cash will likely put a floor under the market.

Whether the next move is up or down, our Grail ETF & Equity Investor will help you identify early trend changes in sectors and help you ride them to profitability. Take a free 14 day trial.
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