Stock markets: reversal time?

By Prieur du Plessis, on May 12th, 2009 posted in: Investment, Markets, Money 10 people had their say - chime in!

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I indicated in Sunday’s “Words from the Wise” review that “the speed and sheer magnitude of the rally argue for markets to either consolidate or retrace some of the past nine weeks’ gains prior to moving higher”.

Is the rally about to be reigned in? While most major stock market indices are encountering resistance at their 200-day moving averages and/or at the early January highs, a few other indicators also warrant our attention.

Two sectors that have been leading the overall market higher during the rally that commenced on March 9 – small caps and technology – have reversed their outperformance, as seen from the turnaround in the relative performance. The first chart plots the Nasdaq Composite index relative to the NY Composite Index, while the second compares the performance of the Russell 2000 Small Cap Index with that of the S&P 100 Index (large caps). A rising relative strength line indicates outperformance and a declining line underperformance.

Source: StockCharts.com

Source: StockCharts.com

I will keep a close eye on these two charts as relative weakness of small caps and technology will not be a good sign for an overall market that is overbought and looking exhausted after its monumental rally over the past nine weeks.

Another interesting-looking chart is that of the S&P 500 Index’s Bollinger Bands. Although a close below the 20-day moving average (dotted blue line) is required to confirm a correction, the fact that the price is touching the upper band indicates a short-term overbought condition. Also, the black line in the bottom section of the chart – measuring the width of the Bollinger bands – has turned up and is signaling expanding bands. This usually points to rising volatility and lower prices, similar to those experienced at the January and February lows.

Source: StockCharts.com

For those who missed the item over the weekend on Adam Hewison’s (INO.com) technical analysis of the S&P 500′s most likely direction and important chart levels, click here to access the video presentation.

I still maintain that US and other mature stock markets are in the process of mapping out a base development formation which probably means toing and froing between policy tailwinds and economic headwinds. It is only natural (and necessary) that profit-taking should set in after the strong advance; a pullback should not be too much cause for concern, provided the levels from which the rally commenced on March 9 hold.

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