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Bulls Out of Momentum

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Higher highs just aren't backed by real market strength.

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If the title to this article looks familiar, it's because it's the exact opposite of an article published on March 5, Bears Out of Momentum.

On March 5, I wrote that the bears were running out of momentum. The following week, March 12, I continued the market-bottoming theme with a follow-up article, Why Divergences Work.

The underpinnings for both articles was the high-probability value in the divergences principles, which states that price action must be accompanied by the internals of the market. Back in early March, price in the form of lower lows wasn't being matched by the internals, which are measured by momentum and MACD.

Well, guess what? That exact same set of circumstances is now in play, only in reverse - higher highs aren't being matched with strength in momentum and MACD (first and second indicators below price). This can be seen very clearly in the accompanying chart.



Moreover, as was the case back in early March, these conditions are nearly across the board, as the divergences aren't exclusive to the US major indices. Even the strongest of the strong in this rally -- such as my favorite emerging market, Brazil -- has nearly exactly the same set of divergence conditions setting up (higher highs in price, non-confirmation by both momentum and MACD).



As if that wasn't enough to cause a bullish investor some concern, the very short-term indicator I track, Slow Stochastics, is edging toward an overbought reading (>80), which tilts the odds even more in favor of a market stall if not outright decline (see third indicator in both charts).

In my experience, when both sets of indicators -- one measuring the near-term strength, the other the very short term -- are flashing warning signs, it's advisable to be more than a touch more cautious, especially after stocks have rallied 32% off its devilishly low of 666 (S&P 500).

Fundamentally Speaking

From a fundamental valuation perspective, there are an increasing number of reasons to be more cautious - most notably, the high P/E levels. At current price levels, the S&P 500 operating earnings for this year must come in around $60 to justify an average times P/E of 15 (15 x 60 = 900). While there may be a good case to be made for an average times P/E of 15, it's hard to deny that these are anything but average times. Fraught with many unresolved problems, I find it hard to buy the average times P/E as being prudent. A number more like 13 or 14 times (thereby producing an S&P 500 fair level of 780 and 840, respectively) seems more appropriate. Yet, I hear talk from certain institutional corners that an above average times P/E, say 18, is appropriate, as such a number fits the inflation climate the US economy is in. I have 2 things to say about this.
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No positions in stocks mentioned.
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