Can stocks break free?

With equities moving to the upper end of a 5-month trading range, a short pullback is likely.

By Anthony Mirhaydari Sep 15, 2010 5:03PM

MirhaydariFor the past five months, the stock market has gone nowhere fast. In fact, if you look at the NYSE Composite Index (NYA.X), shares are trading at the same levels that were first reached way back in October. That's right. Equities have been stuck in one giant trading range for a year.

 

No wonder that for many investors this doesn't feel like a bull market. Nor does it feel like an economic recovery. It just feels like we're all stuck in purgatory -- a churning, slow-growth environment somewhere between recession and full-throttle rebound.

 

So with stocks nudging up to significant overhead resistance levels -- which foiled previous rally attempts in June and August -- the question is: Can stocks move out of the summer doldrums and push to new highs?

 

NYSE Composite

 

Unfortunately, although the long-term outlook is still positive, equities don't seem to have the momentum needed for a decisive break higher. Various technical and market-breadth measures point to a loss of momentum over the past few days. With that in mind, a temporary pullback, perhaps lasting a few days to a week or more, is the most likely scenario from here.

After a rest and a reset, stocks should push higher into the end of the year.

 

The first problem has been the decline in the number of stocks participating in the advance over the past few days. During the big Sept. 1 up day, when there were more than 2,000 net advancing issues on the NYSE. Since then, fewer and fewer stocks are moving higher despite the steady increase for the overall market. In Wednesday's trading, there were just 185 net advancing issues.

 

SPX

 

This is a sign that buyers are narrowing their focus and are finding fewer bargains -- something that often precedes market pullbacks. In the chart above, I illustrate this using a five-day moving average of the number of net advancing issues on the NYSE. You can see how a similar pullback warned of a decline in early August.

 

Other measures of breadth, such as the volume in advancing issues versus the volume of declining issues, corroborates the observation that buyers are losing interest.

 

The second problem is that various technical measures have moved decisively into overbought territory. Moreover, a chart formation known as an "inverse head and shoulders" is being traced out by the S&P 500.

 

Although this just looks like a collection of squiggly lines, it's the result of investor psychology. The first dip offered hope, since stocks bounced off of support from the February low. The second deeper dip crushed bullish sentiment and struck fear in everyone's heart. The third dip confounded the early optimists and set a trap for late arriving short sellers.

Combining these two factors provides a troubling picture. Just as stocks encounter significant resistance from the "neckline" of the head and shoulders pattern -- a formation that is being closely watched up and down Wall Street -- market breadth shows that buyers are much less engaged now than they were in August.

 

The cure for lack of demand, of course, is lower prices. So get ready for a short-term pullback. The weakest sectors heading into a potential dip include energy, industrial, and materials stocks -- so keep an eye on the Energy SPDR (XLE), the Industrial SPDR (XLI), and the Materials SPDR (XLB) for ideas on the short side. Otherwise, it's a good idea to hold off on new purchases until the smoke clears. I'll let you know when.

 

Disclosure: The author does not own or control a position in any  company mentioned.

 

Be sure to check out Anthony's new investment advisory service, the Edge, which is launching this month. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.  

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