Stocks vulnerable to a pullback

After a short but sweet rebound rally, evidence suggests that a pause is in order.

By Anthony Mirhaydari Sep 8, 2010 4:44PM

MirhaydariAlthough I'm still bullish over the long-term, stocks and other risky assets are poised for a short-term pullback in the wake of the impressive rally that's taken the S&P 500 ($SPX) up 5.6% since the end of August. After bounding higher, shares are now meeting overhead resistance while at the same time, various technical indicators have moved into overbought territory. That's not a good sign.

 

Moreover, there are fresh worries over the health of the European financial system on reports this week that recently completed "stress tests" by regulators -- which were intended to boost confidence -- weren't as rigorous as they should've been. This has cast doubt on the entire situation and led investors to bid up safe haven assets like the U.S. dollar. That, in turn, has weighed on commodity prices and equities in general.

 

So while I still expect stocks to move up and out of the multi-month consolidation that has held the broad market indices since May, the situation is vulnerable to a pullback. Here's why.

 

S&P 500

 

From a technical perspective, you can see how the S&P 500 has bonked its head on resistance from both its post-April downtrend as well as its 100-day moving average. Both levels combined to foil the stock market back in early August -- and they're doing it again now. The 100-day average on its own turned the market lower in June. You can also see how the 14-day stochastic, shown in the lower chart pane, is now overbought.

 

For more on the situation, I turn to veteran chart watcher Tom McClellan of the McClellan Market Report. In a recent note to clients, McClellan highlighted two big red flags. The first is that the all 30 component stocks of the Dow Jones Industrial Average (INDU), including the likes of Bank of America (BAC) and Intel (INTC), now have rising price oscillators. This measure, calculated based on moving averages, represents momentum.

 

In Tom's words:

 "It takes a lot of energy to get all of the Dow stocks moving the same direction, up or down, by enough to affect their Price Oscillators ... the expenditure of all that energy can leave the bulls or the bears exhausted and unable to continue."

 

The other red flag is that the CBOE Volatility Index (VIX), known as Wall Street's "fear gauge," dropped nearly 27% in the eight days leading up to the big stock market rally last Friday. Similar meltdowns in risk aversion have been associated with market tops recently -- including the pullbacks in June, July, and August as well as the temporary selloff seen coming out of the February low.

 

The nature of the decline, should it materialize, will determine whether this is a buying opportunity ahead of continued gains; or whether it presages something much worse. Stay tuned.

 

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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