4 Signs That the Rally Could End

As we headed into Labor Day, stocks could muster little enthusiasm. A creeping sense that the economy was slowing led to fresh concerns of the dreaded “double-dip” recession.

The Federal Reserve was also seeing signs of a slowdown. As a remedy, The Fed began to speak of a tool in its arsenal to help jolt the economy to life. That tool, known as Quantitative Easing (QE), changed the entire perception of the stock market. Investors came to see that the Fed’s move had a real chance of getting the economic ball rolling, which was enough to fuel a heady rally in September that has continued into October. The Dow Jones Industrial Average now sits near its 52-week high.

But it’s fair to wonder if this steady gain has already accounted for benefits that may be derived from the Fed’s much-discussed QE plans. And it’s also fair to mistrust these kinds of rallies. The Dow surged more than +10% last February and March only to give back all those gains — and more — in the next few months. Here are four signs to watch that may signal a time for profit-taking.

1. The reaction to news. Earnings season is getting going and investors need to clearly monitor how stocks trade on strong or weak results. Alcoa (NYSE: AA) has tacked on steady gains since reporting solid results last week. But Intel’s (Nasdaq: INTC) solid quarterly report is being met with a shrug on Wednesday, and investors are pushing the stock into the red after a positive open. That means investors were seeing the cup as half full for Alcoa, but half empty for Intel a week later. If shares prices fail to rally in the face of good news, that’s a sign investors are looking for excuses to take profits. You’ll have to track earnings reactions almost every day this month — as sentiment can turn at any minute.

2. Trading volume slumps. If a rally is accompanied by rising stock market volume, then investors are becoming increasingly bullish. Yet success begets success, and markets can still power higher even as enthusiasm starts to wane. It pays to watch the S&P 500’s daily trading volume for signs of fatigue. Daily trading volume appears to have peaked at around 4.5 billion shares in mid-September, and after a lull, spiked back up to 4.2 billion shares at the end of the month. We haven’t seen those levels since, and if daily trading volume slumps back to the 3.5 billion mark as we wind through earnings season, that would be a bearish sign.
3. Fund inflow. The Investment Company Institute (ICI) tracks the amount of money flowing into equity mutual funds on a weekly basis. And since the value of stocks is simply a function of supply and demand, then it figures that the amount of money going into funds affects the direction of the market. A mutual fund manager can opt to keep some of that money in the form of cash, but for the most part, funds need to be put to work to keep up with benchmarks.

In that context, the ICI’s recent readings are awfully curious.

Throughout September, individual investors had been taking money out equity funds, which historically speaking, has pushed averages down. This is a clear negative for the market, and may still come home to roost. Then again, I recently opined that individual investors would be heartened by the recent rally and re-enter the market in force. [See “10 Bold Predictions for the Next 12 Months”]

Let’s hope that individual investors don’t pour in just as the market peters out. Individual investors have a lousy track record in terms of market timing, and they’ve already been burned too many times.

4. Reaction to “Buy on the rumor sell on the news.” As noted above, the Fed’s QE program has not yet gotten underway. Some suspect that recent gains already anticipate any benefits and predict that investors will head to the exits once the QE program is actually put into action. If the market fails to rally on such an announcement, that’s a sure sign that this rally is out of breath and the next move may be to take profits or even go short.

Action to Take –> This is an awfully tricky time. The market has staged an impressive rally, volatility-inducing earnings season is upon us, economic data points still reflect sluggishness, and last-minute mid-term election campaigning could still throw a monkey wrench into the tenor of the market’s mood. So it’s no time for complacency, unless you view your investments as long-term holdings. Be prepared to lock in gains if these warning signs emerge.