Stocks flash warning signs

Technical measures like breadth, volume, and sentiment suggest the market is topping out

By Anthony Mirhaydari Nov 11, 2009 5:10PM

MirhaydariWhile the Dow Jones Industrial Average (INDU) continues to flirt with new highs, there are problems beneath the surface.


Since stocks bottomed late last month, volume on the New York Stock Exchange has been in a sustained decline -- dropping more than 36% in a sign of lackluster buying intensity. Compare this to rises out of oversold conditions in July, August, and September on big increases in volume as investors fought to get into stocks. For example, NYSE volume jumped more than 156% during the rally out of the July low.


Also, the CBOE Volatility Index (VIX.X), which is based on premiums charged on S&P 500 options, has reached its most oversold levels since late January based on its seven-day rate of change.  Remember that the VIX tends to have an inverse relationship with stocks since it represents the level of fear among investors. So when the VIX reaches oversold levels, it indicates that investors are a feeling a bit too cocksure and are vulnerable to a correction.


Nasdaq Breadth


Breadth trends have also been disappointing. The 50-day and 200-day moving average of the Nasdaq's advance-decline issues line has made a downward cross for the first time since late last year. Translation: Fewer and fewer stocks are participating in the rally.


Another point is that differential between large cap performance and small-cap performance that we talked about last week. This sort of divergence can persist for a long time, but narrowing markets are not healthy markets. It's better for the longevity of the move if all groups are rising together or at least with minimal differences. When support for small-caps starts to fade away, it's usually a sign that buyers are crowding into the strongest performers.


Add all of these together -- shriveling breadth in the Nasdaq, weakening volume, weakness in small caps, investor complacency, and extreme relative strength in the big Dow Industrials -- and we might be seeing the early signs of a topping process. These can take a long time to play out, but we can't close our eyes to the possibility.


Unlike bottoms, which are violent and disorderly, tops occur during periods of calm. The fact that the Dow -- the narrowest and yet most closely followed market index -- is powering to new highs all by itself gives the impression of a PR effort by Wall Street insiders holding up the market while they sneak away. Market tops tend to be dull affairs. Even if one can identify its telltale signs in advance, timing is always difficult because a withdrawal of buying power can take months before it results in a large slide in price.


So I'm not recommending drastic action yet. And I don't want to scare you. I want to let you know that these periods of seeming tranquility are the times when an investor must be on alert for a change in the balance of power between the bulls and the bears.


For those that like specificity, veteran market watcher Tom McClellan of the McClellan Market Report is looking for an important low on December 11 or thereabouts. In his words it "should feel ugly, but the July lows are not likely to be exceeded."


My positions


While I don't recommend action for my readers at the moment, I've taken the liberty of transitioning my portfolio at Wall Street Survivor back to a heavily bearish posture with holdings like the ProShares Ultra Short Basic Materials ETF (SMN). For the month, my positions are up 26% versus a 6% return on the S&P 500.


Disclosure: The author does not own or control a position in any of the funds or companies mentioned.


Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at Feel free to comment below.

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