Thursday, November 14, 2013

Your Risk/Reward in SPX is More Than 2:1 Negative

Its very clear that US equities are in a strong uptrend. Not only are the major indices hitting new highs, but a majority of the sectors are, too (thus confirming breadth). This is not, therefore, a "this is the top" post.

SPX is approaching 1800. Over the past three years, each round number milestone (1400, 1500, etc) has been met with a negative reaction of at least 4% and at times more than 10%. On an overshoot to 1820-30, SPX has upside of 2% versus more than 4% downside, a negative profile.

SPX is up against a weekly channel top rail. According to BAML, the measured move from 2009 to 2011 is 1775 (surpassed this week) and the top rail is 1830 by year-end. In the past, hitting top rail resistance has resulted in a negative reaction.

On a shorter time scale, SPX has moved into ever steeper channels: in the next chart, observe the 6-month dashed green, to 4-month solid green to 2-month solid pink trend lines, each one steeper than the one before it.

The obvious pattern has been to move to the other side of the channel on a two-month cycle (lows in June, August, October). The next would therefore be in December. The lower channel line at 1680 is 6% down from here.

SPX is now up 6 weeks in a row.  From the 2009 low, the most up weeks in a row has been 7. To be clear, this is a sign of strength in the market, from which it should make a higher high in 2014.

But it is also extended on a shorter time frame from which it normally takes a break. According to Tom Bulkowski, a 7th week higher in a row has a less than 5% probability. It has happened just 2 times in the past 10 years (including January 2013).

A lot has been said about investor sentiment recently. However, the following chart shows how extreme sentiment (bottom panel) has become in Nasdaq over the past several months. Each reaction has become smaller as the price slope of Nasdaq has steepened. The likelihood is that a larger reaction is building. The longer term lower trend line is more than 10% below today's price.

Similarly, prior extremes in advisor bullishness (over 3) has in the past led to a quite substantial reaction in SPX (data from Ed Yardeni).

And there has been a cluster of buying climaxes over the past several weeks; in the past, these clusters have led to market reactions (data from Sentimentrader).

Arguing against any significant reaction in the next 5 weeks is that they are rare this time of year. Investment managers that are underperforming are aggressive in driving prices higher to year end. Thus, if there is a reaction in the market before January, it is likely to be short-lived. In the chart below, tomorrow is day 11 in November (data from Sentimentrader).