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Now That the Market Looks Good (Technically), is it Time to Turn Cautious?

Tue, Mar 16 2010, 11:30 GMT
by Gabe Velázquez

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In the past week, I've been hearing this type of commentary: Stocks in many sectors (particularly financials) are breaking out, market breadth is good, and momentum is strong. What could possibly take this market down?

The technical stuff is true of course. However, all of this bullish talk (along with other data) brings out the contrarian nature in me, suggesting that the upside for this market is limited, or a correction is forthcoming. In addition, with every passing day, the evidence begins to accumulate that a pullback seems likely.

Let's go over some of the data that leads me to this belief. If we look at the daily chart of the TF (E-mini Russell 2K), which incidentally, has been the clear leader throughout this latest move, we notice that it is up against the weekly area that produced the largest decline. This initiated with the demise of Lehman Bros back in September of 2008. This tells us there are large amounts of longs (owners of stock) that have essentially been trapped for the whole move down, and will act as supply (sellers) on the market at this level. Thus, the Russell should have trouble advancing here.

What's more, in contrast to its Big cap Brethren, the S&P 500, this lesser known, smaller stock index is quite extended, as seen below. This also increases the odds of some type of pullback.

In the next chart (shown below), notice how the XLF (S&P Financial Index) is pushing up against a major resistance zone. With all the hoopla about how well the financials have been doing lately, one might have thought that sector (along with the broader market) would have broken out of its multi-month consolidation last year. However, that's not the case. In fact, the financial sector is not making any meaningful headway, which should be troublesome for those who believe that we're in a new Bull market (which I don't happen to believe).

To put this in "big picture" context, below is the weekly chart of the aforementioned XLF.

Consider the distance away this index is to those same "Lehman Bros" levels (highlighted in yellow) I mentioned earlier on the Russell 2000. You get the sense that this group either has some catching up to do, or alternatively, may become the proverbial albatross around the neck that stymies further upside progress for the market.

The last, and probably the most telling piece of the "turning cautious" puzzle is sentiment. When we talk about sentiment, we're looking at how market participants are feeling, and most importantly, how they express those feelings about future prospects for the market.
This is a contrarian indicator because when people become too bullish, as is the case now, the insinuation is that the bulk of the buying power is spent. My favorite way to track this "risk appetite" is by monitoring what the option-buying public is doing. When the call (Bullish) bets are outpacing the put (Bearish) purchases by a ratio of over two-to-one, I begin to take notice. As of the day of this writing (March 10), the call/put ratio is approaching extreme levels not seen for several months. In other instances where there have been clusters (multi-day) of elevated readings, a correction has ensued. The exact timing and magnitude of the retracement is unknown, but the likelihood of it happening is quite high.

All told, the preponderance of the evidence is pointing towards limited upside for the market in the intermediate term time frame. Moreover, the reward versus the risk for buying here is clearly not good. Note that this is not intended to be a prediction, but a compilation of factors that together add up to a higher probability. With this in mind, now would be a good time to ask the question, who buys or turns bullish after an extended run up? I'll let you ponder that one...

Published on  Tue, Mar 16 2010, 11:34 GMT

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