The S&P is up 4.6% year-to-date. Momentum is clearly positive, but if the S&P kept going at this rate, it would end the year up 80%. Obviously this is impossible and some sort of correction is inevitable.
The question is how long it will take before technical overhead resistance and increasingly troublesome bullish sentiment reel stocks back into reality.
Better than it Looks
As of Friday's close, the S&P has gained 58 points year-to-date. 48 of those points occurred overnight with the gains being reflected in the first hour of trading. There's been no follow through during Wall Street's regular business hours.
Talking the Talk but Not Walking the Walk
Investors are getting excessively bullish (more in a moment) but the conviction behind this rally is non-existent. Average trading volume for the first 12 days in 2012 is less than half of what it was in 2006, 2007 and 2008 and is 42% below the 8-year first 12 days of the year average. The chart below shows just how anemic trading volume is.
Bullish for Better or for Worse
The CBOE Equity Put/Call Ratio dropped to 0.47 last Thursday. This is the lowest reading since February 7, 2011 and means that more than twice as many options traders bet on rising prices than falling prices.
Concerning sentiment, the April 6, 2011 ETF Profit Strategy update warned that: 'The percentage of bearish advisors and newsletter-writing colleagues dropped from 23.1% to 15.7%. Stocks' performance 1 - 2 months following such a spike in bullish sentiment was substantially below normal. This is consistent with our outlook for a late April/May market reversal. According to sentiment, stocks are ripe for a decline.'
Less than a month later, the S&P rolled over into a wicked summer meltdown. About two weeks ago, the percentage of bearish investors dropped to 17.18%.
Of course we can't talk about sentiment without mentioning the VIX (Chicago Options: ^VIX). As the S&P (SNP: ^GSPC - News), Dow (DJI: ^DJI - News) and Nasdaq (Nasdaq: ^IXIC - News) have moved higher, the VIX has dropped to 18.28, the lowest reading since July 22, 2011.
The S&P lost nearly 250 points the 12 trading days following the July 22 VIX low.
Momentum vs. Technical Resistance
The markets relentless rallies of 2010 and 2011 have taught us that it 1) sentiment can always become more stretched and 2) it is dangerous to bet against strong up side momentum.
The 20% meltdowns starting in April 2010 and May 2011 on the other hand, have taught us that it is dangerous and nave to ignore the warning signs of a weakening market.
To profit (or prevent getting burnt) from this tricky situation, investors cannot afford to become complacent and need to be balanced about their decisions. Knowing important support/resistance levels and understanding how we got to where we're at will be a huge asset.
Dead Cat Bounce or New Bull Market
Is the rally from the October 2011 (or from the March 2009) low a dead cat bounce or the beginning of a new bull market?
A few days before the S&P hit its 1,075 low, the October 2, 2011 ETF Profit Strategy update stated that: 'Based on the studies discussed in August 14, I've been expecting new lows followed by a tradable bottom. I define a tradable bottom as a low that lasts for a few months and leads to a bounce that (in this case) should propel the markets around 20%. From a technical point of view, this counter trend rally should end somewhere around 1,275 - 1,300.'
Keep in mind that the prediction of a 20% rally seemed absurd at a time when Wall Street had already proclaimed the next bear market as the headlines below show:
Oct. 4, 2011: 'S&P enters bear market territory' - Reuters
Oct. 4, 2011: 'S&P 500 falls to the bears' - TheStreet
Oct. 3, 2011: 'Think the economy is bad? You haven't seen anything yet' - CNBC
The chart below, published in the October 2 ETF Profit Strategy update, outlined the S&P's journey back to about 1,300. Even though seen as impossible at the time, here we are at S&P 1,310.
Picking a top is always more difficult than picking a bottom, and it takes just as strong of a contrarian stand to sell into a top as it took to buy at the bottom.
Many indicators show that stocks are overbought and ready to roll over. However, relentless momentum and the possibility of QE3 could make it difficult to take a bearish stand and trade accordingly. How can you reduce risk?
Reducing Risk
The S&P responds to support/resistance levels like a car to traffic lights. A traffic light doesn't guarantee the car will stop, but if the car is going to stop, it will usually do so at a light, not in the middle of the road.
Knowing of important support/resistance levels is almost as valuable as exclusive insider information. The S&P's May 2, 2011 top for example occurred within points of the Fibonacci resistance at 1,369 (the April 2 ETF Profit Strategy update stated that: 'The 1,369 - 1,382 range is a strong candidate for a reversal of potentially historic proportions.') and the October 4 bottom was carved out within points of Fibonacci support at 1,088 (the October 2 ETF Profit Strategy update stated that: 'The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery.')
The S&P is once again getting close to a combination of Fibonacci and trend line resistance. If the S&P is going to turn around, it will probably be there. Alternatively, a break below key support will signal that a turnaround has occurred.
The ETF Profit Strategy Newsletter outlines the target range of this rally and the one support, that once broken, will likely accelerate selling pressure. Updates are provided at least twice a week and include short, mid and long-term forecasts.
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