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Wednesday, August 22, 2012 - 10:30
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Wednesday, August 22, 2012 - 17:26
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Wednesday, August 22, 2012 - 10:30

Is the Market Overbought? These Indicators Say so...

Wednesday, August 22, 2012 10:30 AM

August of 2012 has a clear theme for investors. Many of us are using the phrase "hated rally" because we're watching a market move that makes little sense in the context of major headwinds still in place. I discussed these headwinds a few weeks ago, and the S&P 500 has since tacked on another 4%. To the surprise of many, the S&P 500 is back at levels seen in the summer of 2008 -- before the global economy tumbled into recession. The absolute lows for the market, seen back in April 2009, seem like a distant memory.

It's hard to explain away the recent rally except to note that the European crisis has moved to the backburner (for now), talk of a "fiscal cliff" has cooled down from a few months ago (though it still looms) and earnings season wasn't quite as bad as some had feared. Another factor: short sellers who had been betting on a market tumble have been forced to cut losses in a rising market, giving heavily-shorted stocks an especially big lift.

Yet even if you feel that this rally is warranted and anticipate further gains for the long haul, then you still need to heed the technical signals this market is generating. By several measures, we're moving into what market technicians call "overbought" territory, noting that we're hitting key resistance levels.

A troubling MACD
The moving average convergence/divergence (MACD) gauge is often used to spot market trends that have come too quickly. For example, a recent steady rally will show that the shorter-term exponential moving average is outpacing the longer-term exponential average. The last time the MACD was this high was in late March (as seen by the red and black lines at the bottom of this chart), just before the market pulled back. (Conversely, a negative MACD in June presaged a subsequent sharp rally).

Getting complacent?
As noted earlier, investors were obsessed with events in Europe a few months ago, and no longer seem troubled by the prospect of a European implosion. Indeed it appears as if we'll be hearing about the latest efforts to "rescue and stabilize" the weakest European economies during the next few weeks as key leaders sit down to hash out a deal in early September.

But just because these leaders can avert a meltdown doesn't mean that European economies will soon be on the mend. It also doesn't mean we no longer need to worry about systemic shocks to the global economy in the near-term. We're still skating on fairly thin ice. Yet investors have become complacent anyway. The VIX, which is a key measure of market volatility (and investors' fears) has been falling steadily after reaching a fever pitch last fall.

When the VIX has fallen into the mid-teens in the past, investors would have been wise to book profits. "Prior probes into this area coincided with peaks in the equity market in October, 2007, May, 2008, April, 2010, during the December, 2010 to July, 2011 period and in April, 2012," noted analysts at Merrill Lynch in an August 20 note to clients.

Lack of enthusiasm
One of the key supports of a bull market -- or any rally -- is rising volume. A surging market, accompanied by higher trading volumes means that a broad group of investors believe that market is headed higher. Yet trading volume has been quite tepid this summer. In the first five months of this year, there were 11 trading sessions when less than 3.5 billion shares traded hands on the S&P 500. We saw six days of such low volume in June, 12 of them in July, and are on pace to meet or exceed that pace this month.

Think it's just a matter of the summer doldrums as traders are off on vacation? Well, we had only three trading days last August with such low volume, and five days of such low volume in August 2010. Back in August 2009, daily trading volume on the S&P 500 never dropped below 4 billion. The fact that six of the last seven trading sessions have seen volume drop below three billion shares is virtually unprecedented in recent years.

It's as if a party is going on, but few are attending. And what kind of party is that?

Risks to Consider: As an upside risk, upcoming moves by the Federal Reserve or European Central bankers to provide further stimulus could lead to a final leg up in this current rally (though anticipation of such events appears to be increasingly priced into this market).

Action to Take --> Looking for another reason to harvest profits? Strategists at Citigroup suggest that the month ahead is a tough one for stocks. "…despite two market crashes in October, the worst typical month has been September when looking back 60+ years. The explanation may be that the third quarter is less predictable than other quarters due to summer vacation-related corporate sector downtime…leaving it more dependent on the only full month of business activity, which makes accurate forecasting inherently more difficult."

Please heed these warning signs. Investors tend to chase performance, meaning they often start buying stocks after a rally is well underway. Though the market could continue to move higher in coming weeks and months, the risks of a moderate to sharp pullback are rising.

This article originally appeared on TradingAuthority.com:
By These Technical Measures, The Bull is Getting Winded

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.