Stocks vulnerable to a pullback

Signs of trouble emerge as equities enter a historically weak time of the year.

By Anthony Mirhaydari Jun 21, 2010 3:46PM

MirhaydariRisky assets bounced higher in overseas trading today after China finally acquiesced to global pressure and announced that it would once again allow its currency, the renminbi yuan, to start appreciating again. The Shanghai Composite jumped 2.9%, Japan's Nikkei index added 2.4%, and European stocks gained 1%.

 

But American traders are using the good news as cover to sell. As I write this, the smaller and riskier stocks in the Russell 2000 have dropped from a gain of 1.8% to trade with a deepening loss of 0.7%. The U.S. dollar is also moving higher and is trading with its largest gain since stocks bottomed on June 8.

 

With the major indexes overbought in the short term, and after a recent cross of significant technical resistance at the 200-day moving averages on the S&P 500 and Dow Jones Industrial Average, a pause for breath was to be expected. There is evidence, both historical and anecdotal, that stocks have further to fall.

 

RUT

In the chart above, you can see how small caps, which led the initial move out of the June 8 low, have taken a timeout the last few days after Tuesday's big advance. The Russell 2000 has hit its head on resistance from the closing low of the May 6 "flash crash." This looks a lot like the situation back in February. Although it's not shown on a chart above, stocks made similar pauses coming out of the November low and the July low last year.

Another sign of trouble was the big fat reversal on the CBOE Volatility Index (VIX) we saw today -- which is also known as Wall Street's "fear gauge" because of its ability to measure the sentiment of traders. Since stocks bottomed on June 8, the VIX had posted the largest and fasted drop since mid-2006. But now, as options traders move to protect themselves from a market fall, the VIX has gone from an intra-day drop of 4.5% to trade with a gain of 6.3%.

 

As mentioned above, a number of short-term indicators have moved into overbought territory. Nearly 92% of stocks are above their 10-day moving average. Investor sentiment has also improved (which is negative from a contrarian's perspective). And the Tuesday, June 15 rally also qualified as a 90% up volume day -- such overwhelming buying frenzies are normally followed by a brief respite. All of this suggests that a moderate pullback is needed to shake the weak hands and clear the deck for new push higher.

 

One more point: Historically, the week after June options expiration (which was Friday) has been troublesome. The Dow has been down 10 years in a row for the week after June expiration -- and down 17 of the last 19 years.  That's a pretty abysmal record.

 

So while it looks like we'll get a scary move to the downside this week, I think it'll be short-lived. My indicators suggest this intermediate term uptrend is just getting warmed up. So we'll be buyers on any pullback. If you're waiting to put new money to work -- I suggest holding off for a few days to see how things shake out.

 

I used the early morning rally to sell my long positions and add a number of new shorts to my portfolio at Wall Street Survivor. I'm up 7% for the week so far.

 

Consumer stocks look particular weak right now, especially the likes of Quiksilver (ZQK) and Brunswick (BC). I've also added positions in the iPath VIX ETN (VXX), to gain exposure to the bounce higher in the VIX, as well as the Direxion Daily Emerging Market 3x Bear (EDZ), to profit from broad market weakness and the resurgent U.S. dollar. 

 

Watch me trade during the day at Wall Street Survivor.

 

Disclosure: The author does not own or control a position in any  company mentioned. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below. 

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