DOWNSIDE CORRECTION HAS STARTED AS OVERBOUGHT MARKET PULLS BACK FROM JANUARY PEAK AND 200-DAY AVERAGE -- SHORT-TERM MCCLELLAN BREADTH OSCILLATOR TURNS NEGATIVE -- THE LONGER-RANGE SUMMATION INDEX, HOWEVER, HITS FIVE-YEAR HIGH
MARKET FAILS TEST OF JANUARY HIGH ... I started the week on Monday with the headline that "Upside price and time targets had been hit" and added that overbought readings suggested that the market was vulnerable to profit-taking. The NYSE Composite Index had just reached overhead resistance at its January high and its 200-day moving average as shown in Chart 1. A number of other indexes (like the Nasdaq Composite in Chart 2) and sector indexes were stalled at their 200-day moving averages as well. So were numerous foreign stock markets. Chart 3 shows the MSCI EAFE (Europe Australasia and Far East) Index stalled at its January high and 200-day line. It was no surprise then to see global stocks selling off this week. When a market has rallied too far and is ripe for profit-taking, some fundamental trigger usually starts things off. A weak retail report on Wednesday caused stocks to sell off on heavy volume and got the correction started. After a modest bounce on Thursday, stocks fell again on Friday. The result was a weekly loss for all of the major stock indexes. I also suggested that a pullback to the 50-day moving average was likely and could be part of "right shoulder" in a bottoming formation. Arthur Hill expanded on that idea during the week. In addition to some fundamental trigger, there are technical triggers as well. Chart 1 shows two examples. The 14-day RSI line (top of chart) broke its two month support line after reaching overbought territory at 70. The MACD histogram bars (below chart) turned negative (red circle). There were other technical triggers as well.
Chart 1
Chart 2
Chart 3
MCCLELLAN OSCILLATOR TURNS DOWN... A month ago (Friday, April 17), I wrote an article on the two McClellan breadth indicators. I pointed out that the shorter-term McClellan Oscillator (NYMO) had turned positive which was supporting a stock market rally. The NYMO is a market breadth indicator that is calculated each day by taking the difference between the 39-day and 19-day exponential moving averages of the number of net advances on the NYSE. Readings below -100 mark oversold levels while reading over 100 are overbought. Short-term buy and sell signals are given when the NYMO crosses above and below its zero line. Four such crossings are shown since last November in Chart 4, with the NYMO turning negative this week by falling below its zero line for the first time in six weeks. That's further evidence that a downside correction has started. The bigger question is whether this is just a normal pullback (and buying opportunity) or the end of a bear market rally (selling opportunity). I lean toward the first view. One of the reasons why is the strong action in the McClellan Summation Index which is the longer-range counterpart of the NYMO.
Chart 4
SUMMATION INDEX HITS FIVE-YEAR HIGH ... The Summation Index (NYSI) is the longer-range version of the NYMO. The NYSI rises when the NYMO is positive and falls when the NYMO is negative. While the NYMO is used to gauge changes in short-term trends, the NYSI measures longer-range NYSE breadth momentum. Chart 5 shows the Summation Index peaking in late 2006 and falling below its zero line in mid-2007. That was one of the indicators that helped turn me bearish in the second half of that year (which I described in the Second Edition of the Visual Investor). After bottoming at the end of 2008, the NYSI crossed back above its zero line this spring and exceeded its 2008 peak. Even more impressive is the fact that it has reached the highest level in five years. That doesn't look like bear market action to me. Over the short-run, the NYSI is overbought and has weakened for the first time in two months (because the McClellan Oscillator has turned negative). The fact that the NYMO has turned negative suggests that the market has entered a downside correction. The fact that the NYSI has rallied so strongly suggests to me that the current pullback is most likely part of a bottoming pattern and a buying opportunity.
Chart 5
WHAT TO DO ... A couple of weeks ago I suggested that the start of May wasn't a good time to buy stocks for seasonal reasons ("sell in May") as well as the fact that the market was overbought and up against resistance. I suggested that a pullback (right shoulder) should provide a better buying opportunity at lower levels. I still feel that way. I also still believe that new commitments should be done gradually and not all at once. The market needs more base-building to support higher prices later on. I'd be more inclined to do some bottom-fishing closer to 50-day moving averages. I favor groups that showed upside leadership during the spring rally that include consumer discretionary stocks, basic materials, energy, and technology. [Commodities are correcting along with stocks]. Some money has begun moving back into precious metals. That may be one of the best places to park some funds during the current market correction and as a hedge against future inflation. Treasury Inflation Protected Securities (TIPS) are also attracting new money. Chart 6 shows Lehman TIPS iShares (TIP) trending higher. TIPS provide some fixed income stability and inflation protection. That's another asset worth holding. Emerging markets, especially those tied to commodities, are also showing signs of global leadership. At the moment, however, they too look over-extended and in need of correction. Brazil and China would be my favorites once the current correction runs its course.
Chart 6
