Stocks are likely to falter

After a historic performance for the month of September, equities struggle to overcome resistance.

By Anthony Mirhaydari Sep 29, 2010 3:02PM

MirhaydariDefying expectations of a typical September selloff, stocks have instead pieced together a historic rally -- which was what I expected back on September 1. For the month to date, the S&P 500 is up 9.2%. That's the best performance for the month of September since 1939. Since 1928, Septembers have on average posted a loss of 1.2%.

 

In fact, using market price information going all the way back to the late 1700s thanks to the work of Global Financial Data, the past month has been second best September in the history of the American stock market. Runners up in include the 8.3% gain in 1954 and the 8.1% gain in 1891.

 

But now, after a historic run, there is evidence that a pullback is increasingly likely. Stocks, represented by the S&P 500 ($SPX), have hit solid resistance from January's highs near 1,150. Breadth continues to narrow as demand fades. Here's what you need to know.

 

SPX

 

The chart above says it all.

 

You can see how the S&P 500 has traced out a huge "head-and-shoulders" reversal pattern this year. The left shoulder was established by the January high. The head was the April high. And now, if stocks turn tail and move lower, the right shoulder will be established.

 

Using the distance from the head to the "neckline" -- which is about 1,220 to around 1,030 -- gives us a price target. And it isn't pretty: 840, which would be worth a 27% decline from current levels.

 

To be clear, I don't a drop of this magnitude. Long-term measures of market breadth, valuation, earnings power, interest rates, risk premiums, and leading indicators of the economy all suggest higher prices lie ahead.

 

But a short-term pullback, one that will surely increase talk about the reversal pattern outlined above, looks increasingly likely.

 

Two big red flags have made me cautious.

 

The first is that the measure of Wall Street angst, the CBOE Volatility Index ($VIX), hasn't corroborated the recent push to new rally highs by dropping down out of its three-month trading range. That suggests that professional traders are still demanding the portfolio insurance offered by option contracts -- and are willing to pay a premium for them.

 

The second is the fact that fewer and fewer stocks have been participating in the advance over the past few days. Just look at today's action: At one point, Boeing (BA) and HP (HPQ) accounted for 65% of all the points gained by Dow Jones Industrial Average. With the major equity indexes held up by just a few issues, which the rest are sold, it's clear that the demand for stocks is beginning to wane.

 

Fear, lack of demand, and increased supply (from overhead resistance) is a classic recipe for lower prices. For now, investors should hold off on new purchases. But once the decline gets started, it'll be time to accumulate.

 

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

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