Trend remains up in spite of fundamental weakness
Although the stock market seemed to struggle a bit over the past week, the overall trend remains up. An improved jobless claims number and improved retail sales in October are likely to boost stocks over the short-term and technical and cyclical indicators seems to be showing the same.
Regular readers probably know that I do not believe that the economy is in recovery mode. I am convinced that the fundamental factors remain weak and that it will be years before the economy is back to the levels of strength we saw in 2006 and early 2007. But obviously Wall Street and the investment world in general does not care what I might think.
For now, I think traders are short-sighted and focused on any positive data that is of the “less bad” variety—as in “the latest report still shows poor numbers, but it isn’t quite as bad as we were expecting.” As a result, the markets continue to advance because many investors are buying on the hope that things will soon return to normal.
One of the strengths of technical indicators is that they do not account for emotion or even for fundamental economic data. All they do is reflect what has happened in the markets. And while some argue that this is like trying to deduce what is ahead by looking in a rear-view mirror, that is often the most accurate information available.
Take a look at the chart below of the New York Stock Exchange Composite. From the black line showing price movement of the past year, we can see that stocks pulled back over the past couple of weeks but started advancing again over the past few days. We can also see that a similar situation occurred four times since July.
Stocks have risen steeply since March. While the pace of that rise has slowed, (as indicated by the blue and yellow trendlines) so far there is nothing to indicate that the rally is over.
The middle portion of the chart is a slow stochastic oscillator. It is a tool designed to measure random cycles. It is very reliable at identifying when stocks have reached overbought or oversold extremes. In other words, when the oscillator climbs above 80, a downturn in stock prices is likely. When it falls below 20, an upturn in stock prices usually follows. This oscillator turned positive in late October and is now rising. It is about the 50 level, indicating that we should see several more sessions of rising stock prices before it eclipses the 80 mark.
The bottom section of the chart is a relative strength indicator. It has just crossed back above the 50 mark. Normally that indicates a situation where stocks are gaining strength and should continue to rally for at least a few sessions. I added the red line to show that while stocks have been rallying to successive highs over the past few months, those rallies have shown declining strength. The disparity between what the indicator is showing and what the market is actually doing is called negative divergence. Changes in market trends are sometimes preceded by negative divergence.
Based on these indicators, I would not be surprised if stock prices keep rising for another couple of weeks before the next downturn begins. Whether or not that downturn will become a major correction I cannot predict. But I still believe that market risk remains high and a significant double-digit decline will occur sometime in the next several months.
F.S.