Caution Flag Waving

Market internals are deteriorating, momentum is waning, and optimism is healthy -- a prescription for a pullback or correction

The stock market wasn't in the giving mood this week as the major indexes all fell, somewhat of a rarity since August. Bond yields consolidated near the 4.6% zone, while crude oil prices bumped up against some key resistance.

The mid-December recovery high posted by the S&P 100 and S&P 500, and the all-time closing high by the DJIA, was not confirmed by other indexes, however. The Nasdaq, Nasdaq 100, S&P SmallCap, S&P MidCap, and Dow Transports all failed to set new highs. This indicates to us that institutions are getting more selective and defensive as they funnel into the mega-caps. So, not only do we have waning momentum, but deteriorating market internals, as well as a healthy dose of optimism. Many times, this is a prescription for a pullback or correction.

Speaking of optimism, the daily CBOE equity-only put/call (p/c) ratio was only 0.45 on Dec. 21, the lowest reading since Apr. 3, and one of the lowest daily readings over the last four years. The trend of the equity-only put/call ratio has fallen sharply since the beginning of October, as option investors become more and more bullish. This has helped the overall market, but this indicator is starting to get into the danger zone, in our view, as too much optimism can be a bad thing once it goes the other way. The 30-day equity-only p/c ratio has dropped to 0.587, the lowest since early May when the ratio fell to 0.582. This time period was just before the market rolled over and corrected into June and July. The 5-day equity-only p/c ratio has fallen to 0.54, very close to the lowest level since late April. As we mentioned last week, the total CBOE put/call ratio was 0.64 on 12/14, which was also one of the lowest readings over the last couple of years.

Another sentiment indicator showing an extreme in bullish optimism is the Investor's Intelligence poll of newsletter writers. The latest readings are 58.8% bulls and only 20.6% bears. Bullish sentiment is off one percentage point from the recent high two weeks ago of 59.8% bulls. The bearish reading of 20.6% is the lowest percentage of bearish sentiment since the week of Aug. 12, 2005. This was right before the market pulled back into the October 2005 lows. The ratio of bullish sentiment to bearish sentiment has climbed to 2.85, the highest since late December 2005. This ratio has risen all the way from 1.00 in June.

Just as sentiment is reaching extreme optimistic levels, negative divergences with respect to market internals are popping up all over the place. The key to these divergences is that they are all occurring after getting fairly overbought, just like we have seen with many daily momentum indicators. The number of NYSE 52-week highs plus the number of Nasdaq highs reached an overbought level of 761 on Dec. 5. The summation of new highs has been climbing since bottoming out in June.

However, while the S&P 500 posted new recovery highs on Dec. 14 and 15, the summation of new highs posted a lower high of 509 on Dec. 14. This is the first major divergence with this internal indicator, and shows fewer stocks are matching the strength of the S&P 500. On the flip side, the summation of NYSE lows and Nasdaq lows bottomed out at an overbought level of eight issues on November 24, down from the most recent peak of 515 on June 13. This internal indicator has started putting in higher lows, even though the S&P 500 made higher price highs after Nov. 24, and has now traced out two bearish divergences.

Because the Nasdaq has been underperforming the S&P 500 since Thanksgiving, there has been more noticeable deterioration in the Nasdaq's market internals. For instance, the 30-day simple moving average of declining volume on the Nasdaq has been rising since Sept. 20, even though the Nasdaq's last peak occurred on Nov. 22. Often, this internal component of the Nasdaq will rise for months before the indexes peak out on an intermediate-term basis, giving us plenty of warning that a market top is coming. Before the correction that started in May, declining volume rose for 5 months prior to the market turning lower. The peak in August 2005 was preceded by 1-1/2 months; during the top in December 2004 the lead-time was three months; and before the crest in January 2004, declining volume rose for 4 months. So with 3 months behind us, the caution flag is certainly waving.

There has also been deterioration in the number of Nasdaq new highs relative to the number of issues traded on the Nasdaq. After peaking up near 9% of issues traded in mid-November, the percentage of new highs on the Nasdaq has fallen all the way to the 1% to 2% range. In the process, this internal indicator put in one negative divergence and has traced out a series of lower highs and lower lows. In addition, the 20-day exponential average of this indicator has crossed below the 45-day exponential average, giving the first sell signal for this internal measurement since May 12. This crossover method had been on a buy signal since the end of August.

A key zone of support for the S&P 500 is located between 1380 and 1400. There are two trendlines that come in near 1400, the 50-day average sits at 1390, and the bottom of the 21-day price envelope comes in at 1381. There is minor chart support in this zone as well. If the index takes out this area of support, a 5% correction of the recent high of 1427.09 would take us to 1355, which is close to a 38.2% retracement of the rally since June. A 50% retracement of the rally targets the 1325 level, a more significant zone of support because it represented the top of the move back in May. While the S&P 500 has yet to breakdown (put in a series of lower highs and lower lows) and has not yet traced out a bearish reversal formation, there are plenty of warning signs that leave us cautious.

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