Mid-week market update: Even as stock prices weakened this week, the market appears to be setting up for a year-end rally. The SPX is exhibiting a number of positive divergences. Both the NYSE and NASDAQ new lows are not spiking even as stock prices have fallen. In addition, the percentage of stocks above their 50 day moving averages (dma) are making a series of higher lows, which are all bullish.
What are the risks and opportunities in positioning for a year-end rally?
The bull case
The tactical bull case is relatively easy to make. Sentiment is becoming washed-out. The latest Investors Intelligence bull-bear spread is at levels seen in recent intermediate bottoms.
SentimenTrader also observed that Rydex traders are panicking, which is contrarian bullish.
I recently highlighted analysis from Mark Hulbert which indicated that market timers have become excessively bearish, which is contrarian bullish. Hulbert wrote that these readings create an equity bullish environment for the next couple of months, which is consistent with the year-end rally theme.
Contrarian analysis isn’t always right, and even when it is it only applies to the short term — no more than the next month or two. So today’s encouraging sentiment picture tells us nothing about where the market might be six months to year from now.
But, for now at least, contrarians are betting that the stock market will higher over the next couple of months.
I also pointed out that we have seen a cluster of corporate insider buying. Even if you are bearish longer term, which I am, such signals resolved themselves with short-term rallies during the period after the 2007 market peak.
Don`t get too bullish
Should a rally into year-end materialize, I would refrain from becoming overly bullish for a number of reasons. First, investors have to contend with the long-term sell signal flashed by the combination of negative monthly RSI divergence and MACD sell signal.
In addition, the market has been reacting to news from China (see Assessing the odds of a US-China agreement). Despite the encouraging signals, it is difficult to believe that any substantive agreement can come out of the Trump-Xi meeting in Argentina at the sidelines of the G20 summit November 30 – December 1. Be prepared for disappointment.
Two tests for the bulls
Nevertheless, the stock market is poised for a relief rally from a technical and sentiment perspective. There is an inverse head and shoulders formation that is forming in the SPX. Good technicians know that these formations are not confirmed until the neckline breaks. If the index were to break through neckline resistance, the measured target would be about 3035, and such an event would likely spark an initial but brief FOMO rally.
Hold your enthusiasm. Here are some challenges for the bulls. First, the longer term weekly chart shows that the SPX broke down through an uptrend. While the market kissed the underside of the trend line last week, it did not break through on a closing basis. One of the key tasks for the bulls will be to break up through the trend line, otherwise any year-end rally would be interpreted as a failed backtest and likely fizzle out with a lower high.
In addition, watch for breadth thrusts. Past rallies have seen breadth thrusts (circled), as measured by the new high-new low % indicators, in one or more of large caps, midcaps, small caps, or NASDAQ stocks.
If the bulls cannot pass these two simple tests, then any upside breakout of the inverse head and shoulders is likely to be disappointing. Rallies will either be weak, abbreviated, or both.
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Disclosure: Long SPXL