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Monday, December 16, 2013 - 07:00

Are These Market Indicators Signaling Trouble Ahead?

Monday, December 16, 2013 - 7:00am

With just a couple of weeks left in the year, the stampeding bull is starting to wheeze.

Ever since investors celebrated the recent monthly employment report with a nearly 200-point surge in the Dow, the trading mood has turned darker. The market is fell roughly 2% last week, the biggest weekly fall since mid-August.

And even as the major indices still trade near their all-time highs, several technical indicators are flashing red. They may just be sign to tread with caution, or a harbinger of a broader market reversal. That's why some leading traders suggest a tight grip on stop-loss orders. Placing a stop-loss limit order roughly 5% to 10% below current prices can provide a lot of peace of mind.
Here's a closer look:

1. Surging New Lows ​
One of the most remarkable aspects of this year's bull market has been its breadth. So many stocks have rallied, and only the absolute duds have fallen sharply. In fact, the number of stocks on the NYSE hitting new 52-week highs has handily outpaced the number of new lows all year long. But that's changing.

On the Friday after Thanksgiving, new highs on the NYSE outnumbered new lows 12 to 1. Now, that relationship has flipped. More than 220 stocks on the NYSE hit fresh 52-week lows on Thursday, the highest number of 2013.

Why does this matter? Because if the broader market falls further, in tandem with these rising new lows, it will be a "bearish confirmation" that even more market weakness lies ahead.​

2. A Rising 'Fear Gauge'​
The 2013 bull market has been characterized by a complete lack of concern about a pullback. The VIX, a measure of expected market volatility, has plunged to lows not seen in years. As I noted a month ago, some ETFs that focus on the VIX were posting absolutely disastrous returns this year.

But as the Federal Reserve gets set to throttle back on its massive quantitative easing (QE) program, this fear gauge is slowly rebounding. Even as the market hit fresh new highs on several occasions in recent weeks, some investors are growing nervous.

To be sure, the VIX has spiked up several times this year, only to recede when the market marched higher. But it has never at any point moved above 21 this year, which makes that a useful price point to watch for the VIX. If it breaks through that level, then a bold market reversal may be at hand. ​

3. Uncomfirmed Highs With The MACD​
As the S&P 500 Index kept touching new all-time highs in November, a troubling technical trend emerged. This index's MACD (Moving Average Convergence Divergence) reading began to turn south. MACD is derived from a complex calculation, and as that explanation notes, "If the main line crosses the trigger line from above, this is a sell signal."

Well, that's what is happening now. The transition began around Nov. 18, even as the S&P 500 was poised to break new highs on a few more trading days. This divergence has grown in recent sessions, which is seen as a troubling technical sign of a market losing momentum.

4. Too Much Optimism​

The mood of individual investors can often be seen as a contrarian indicator. At times of maximum bearishness, the markets tend to rally, as I noted in a recent column.

And it's equally concerning when stocks are being loved too much. According to the most recent sentiment survey by the American Association of Individual Investors (AAII), the eight-week moving average of bullishness has hovered in the 42 to 43 range, which is the highest it's been for that length of time since the start of 2013.

The logic is simple. When investors are quite bullish, they already have much of their money already in the market, and there is little buying power in reserve. (The converse, when sentiment is bearish, means a lot of cash is ready to go to work in the market).

To be sure, these aren't euphoric times. Investors are cognizant of the challenges. But to repeat my favorite Warren Buffett quote, "Once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks." And if that explains why investors are bullish, then you should be concerned.

8-week moving average of investor bullishness

Source: AAII

Risks to Consider: As an upside risk, market direction comes from money flows, and the increasingly bright U.S. employment picture could lead more investors to deploy excess savings into the market as confidence grows.

Action to Take --> The number of stocks hitting new lows is especially troubling. It implies that many stocks are not enjoying the market party that has been underway for several years. If the troops aren't following the generals, then it's hard to conquer new heights. As I mentioned, stop-loss orders slightly below current prices can provide a lot of peace of mind.

P.S. Are you terrible at knowing when to sell? You're not the only one. Fortunately, a former trust fund manager created a two-part blueprint that reveals when to sell... and when to buy. It's been 85% accurate for over four years -- and just closed out a 70% gain. Click here to access it now.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.