In The Week Ahead: Waning Bullish Momentum May Be Signaling A Peak

John Kosar's picture

Tuesday, December 27, 2016 - 4:30pm

by John Kosar

Major U.S. indices advanced modestly last week, with most tacking on 0.5% or less. This suggests expectations for lower corporate taxes and fewer regulations from a Trump presidency may be fully priced into the market. 

If this is indeed the case, I believe it will open the door for a period of seasonal weakness during the first quarter, similar to the one we saw last year, which resulted in an almost 19% decline in the broader market S&P 500 from the Dec. 29 high to the Feb. 11 low.

From a sector standpoint, the market was essentially split down the middle last week, indicating investor indecision. Financials, technology, industrials and utilities outperformed the S&P 500, while real estate, materials, health care, energy, and consumer discretionary underperformed. 

Keep Watching Overhead Resistance
In last week's Market Outlook, I pointed out that the Dow Jones Transportation Average was testing major overhead resistance at its 9,310 November 2014 high. I said that as long as this level continued to hold, it suggested the correction I've been expecting may finally be beginning.

This week's first chart shows the NYSE Composite also recently tested and failed to break overhead resistance at its 11,255 May 2015 high. Along with 9,310 in the Dow transports, I view this resistance level as a potential starting point for an overdue pullback in the stock market.

The good news is that the NYSE Composite chart also shows a bullish inverse head-and-shoulders pattern that was confirmed in July. The pattern targets a run to 12,300 once 11,255 resistance is finally broken, which implies upside of nearly 11%. 

Momentum Offers Another Warning For Bulls

Over the past month or so, I have introduced a number of different metrics that collectively warn of the stock market's vulnerability to a corrective decline. This week, I have another one to add to the list: overextended price momentum in the S&P 500 according to the Moving Average Convergence/Divergence (MACD) indicator.

MACD is a popular momentum metric that plots the difference between the 12-day and 26-day exponential moving averages. In the lower panel of the next chart, we can see MACD appears to be peaking and turning down from a positive momentum extreme. Similar extremes have previously coincided with most of the significant peaks in the S&P 500 since late 2014.

This chart tells us positive momentum in the S&P 500 appears to be stalling and supports my contention that overhead resistance levels in the Dow transports and NYSE Composite will hold into early 2017.

Low Volatility Remains Problematic
Another near-term red flag for the stock market that I have been discussing for the past month is historically low volatility according to the Volatility S&P 500 (VIX). The VIX finished last week at 11.44, below the 12 threshold that has closely coincided with every near-term peak in the S&P 500 since April.

History shows that as long as volatility remains this low, the market's upside is probably limited without a correction first to put just a little bit of fear back into the marketplace, i.e., that "wall of worry" that the stock market likes to climb.  

If the VIX can move above its 50-day moving average this week, currently situated at 14.16, I will view it as evidence that enough worry has emerged to trigger and fuel an overdue market pullback.

Lumber Prices Suggest A Strengthening Economy
In the Sept. 6 Market Outlook, I highlighted an emerging breakout in the iShares Global Timber & Forestry (Nasdaq: WOOD), saying it targeted an 18% run to $60. Rising lumber prices typically suggest a strengthening housing sector, and housing prices have historically been positively correlated to the S&P 500.

In the Nov. 28 report, I pointed out that after advancing roughly 4%, WOOD was testing formidable overhead resistance at its $52.47 December 2015 high, noting it could trigger a corrective pullback.

But WOOD cleared that resistance level without hardly slowing down. And after trading as high as $55.27 on Dec. 8, it is re-testing this previous resistance level as underlying support.

If its bullish trend is still healthy and intact, which it appears to be the case, the $52.47 area should now loosely contain prices on the downside and may become the springboard for the next move that gets us to my $60 target.

Putting It All Together
A number of metrics, including waning momentum, low volatility and first-quarter seasonality, continue to warn that the stock market's near-term upside is limited without at least a minor corrective decline first. I'm watching the 9,310 area in the Dow Jones Transportation Average and the 11,255 area in the NYSE Composite as potential starting points for a pullback as the post-election rally appears to be running out of gas.

Bigger picture, however, the bullish pattern in the NYSE Composite suggests the index could rally another 10%-plus. The strength in economically influential lumber prices suggests more strength in equity prices overall into the second quarter as Wall Street continues to celebrate the lower taxes and fewer regulations that President-elect Trump promised throughout his campaign.

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John Kosar 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.