S&P 500: 7 Factors Leave a Split Decision Between Bulls and Bears

After years of smooth sailing off the 2011 low, US stocks are suddenly caught in a whirlwind of bullish and bearish crosswinds. In times like these, it behooves traders to take a step back and look at the bigger picture:

The Bull Side:

1) Q3 Earnings and GDP Have Been Strong

On the bullish side, the S&P 500 is in the midst of a strong earnings season. Research firm Factset reported earlier this week that 75% of companies have beat earnings estimates and 60% of companies have beat revenue estimates – both figures were above the one- and five-year averages. Meanwhile, we just found out this morning that economic activity as a whole (GDP) expanded at a strong 3.5% rate q/q, providing a strong backdrop for the remainder of earnings season. As long as corporate profits continue to rise, traders will favor continued gains.

2) Recent Bullish Price Action

Switching our attention to the chart, the recent price action in the S&P 500 has been very constructive. After breaking to a new low, the index found support around 1820, ahead of even the shallow 23.6% Fibonacci retracement of the rally of 2011’s low, signaling that the bulls still maintain the upper hand from a longer-term perspective. More immediately, the index carved out a clear Morning Star* candlestick formation on the weekly chart (below); this relatively rare 3-candle reversal pattern shows a shift from selling to buying pressure and is often seen at meaningful lows in the market.

* A Morning Star candle formation is relatively rare candlestick formation created by a long bearish candle, followed a small-bodied candle near the low of the first candle, and completed by a long-bodied bullish candle. It represents a transition from selling to buying pressure and foreshadows more strength to come.

3) Secondary Technical Indicators Remain in Bullish Territory

While they’ve deteriorated slightly in the past two months, both the RSI and MACD indicators remain in bullish territory. Two weeks ago, the RSI found support at ahead of the key 40 level, which typically marks the floor in an established uptrend. Meanwhile, the MACD indicator has turned lower, but is still above the “0” level, showing generally bullish momentum in the index.

The Bear Side:

1) The Fed is (Gradually) Turning Hawkish

As we noted yesterday, the Federal Reserve struck a slightly-more-hawkish-than-expected tone in yesterday’s monetary policy statement. While many global banks are erring on the side of more stimulus, the Fed appears cautiously optimistic that the world’s largest economy will continue its modest growth in the months to come. With the era of QE behind us (at least for now!) and the Fed looking toward raising interest rates midway through next year, the massive monetary tailwind that stocks have enjoyed for the past five years may be coming to an end.

2) Long-Term Valuations are Stretched

While short-term valuation measures like the P/E ratio and forward P/E ratio are near or slightly above their historical averages, longer-term valuation measures, including the cyclically-adjusted P/E ratio and Q ratio, are historically elevated. These valuation measures are by no means a short-term signal to buy or sell, but they do suggest that the strong, consistent rally we’ve seen off the cheaper levels of five years ago is unlikely to repeat. One way or another, more volatility and uncertainty is likely moving forward.

3) S&P 500 Testing Key Resistance

In the early October selloff, the S&P 500 broke below its widely-watched 2-year bullish channel in the upper 1900s. Following the aforementioned bounce over the past two weeks, stocks are now testing the underside of that previous support level, which based on the polarity principle of technical analysis, should now provide resistance. Unless or until the index can clear this barrier in the 1990-2000 zone, bulls may want to exercise some short-term caution (of course, if this barrier is broken, a surge to new all-time highs is likely).

4) Big Divergences in the RSI and MACD

The final feather in the bears’ cap from a technical perspective also comes from the weekly RSI and MACD. Though the indicators remain in bullish territory, they have both been forming a bearish divergence since peaking back in January of this year. These bearish divergences are not a sell signal in and of themselves, but they do suggest that the uptrend is losing momentum and may be vulnerable to a deeper pullback.

Let’s Go to the Scorecard…

Totaling up these seven (admittedly somewhat arbitrary) indicators, we have a split decision between bulls and bears. For equity traders, this suggests keeping a flexible outlook on US stocks and watching the price action above all. In the short-term, more consolidation or another dip is favored below previous-support-turned-resistance in the 1990-2000 zone, but if the S&P 500 can clear that hurdle, new all-time highs are likely heading into the final two months of the year.