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  • Stocks have made a big move since mid-October.
  • Breadth indicators are flashing warning signals.
  • The S&P 500 has retreated to key support.

The million-dollar question is whether the mid-October run-up will be yet another disappointing bear market rally or the start of something bigger. I’ve been cautious in Smarts lately mainly because the market has entered the stall zone, near levels where a bear market rally would be expected to end.

So far, this stall zone has seen lots of churn and little progress. While the S&P 500 was able to poke its head above its 200-day moving average to close out November, it’s fallen every day so far this month. That’s not a great sign, given the first few days of every month typically tilt bullish because of fund inflows and early month repositioning.

The S&P 500 has now retreated below its 200-day moving average. The Dow Jones Industrial Average  (DIA)  and S&P 400 Mid Cap Index  (MDY) , both of which did better during the rally, have similarly pulled back and are currently sitting atop support at the 21-day moving average and 200-DMA, respectively. Meanwhile, the technology-heavy NASDAQ, which has been a laggard, remains well below its 200-DMA and is now flirting with 21-DMA and 50-DMA support.

If the major market indexes fail to hold support on this pullback, investors face an ugly move lower into year’s end.

The market is overbought

In October, Top Stocks’ Helene Meisler correctly identified a significant market low thanks to her advance/decline oscillators. Terrible breadth (advancers minus decliners tilted heavily to decliners) over the preceding 10 days and 30 days flashed oversold, an encouraging sign given other contrary indicators also said investors were too bearish, such as sentiment measures.

Now, Meisler’s short-term oscillator, measuring 10-day breadth, is overbought. The intermediate-term oscillator, measuring the past 30 days, is also overbought.

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Sentiment measures aren’t nearly as cooperative as they’ve been, either. The CBOE’s put/call ratio is slightly above 1 today. A reading north of 1.2 would be more in keeping with setting the stage for an oversold rally. The AAII Sentiment Survey showed 40% of respondents were bearish last week. That’s more than the prior week but still far below the 56% in mid-October. CNN’s Fear/Greed Index, which comprises a number of sentiment data points, remains at “greed.”

Bearish oscillators and arguably neutral to bullish sentiment aren’t the only worrisome things. A look under-the-hood at action within important sectors is discouraging.

Transportation stocks often hat-tip market action, and they’ve stalled. Also, banks have been leaders, but recently, they’ve lost their luster. Meisler writes:

“Transports, which made a lower high last week, … are flirting with this uptrend line, and a break of it (likely) would not be bullish… The banks actually broke that uptrend line, and relative to the S&P, they are now where they were in late 2020.”

This week, Real Money’s Bruce Kamich also weighed in on financials with a worrisome takeaway. After digesting the daily and weekly charts of the SPDR Select Financials ETF  (XLF) , he writes:

“In this daily bar chart of the XLF below, we can see that prices found buying interest (support) in the $31-$30 area several times in the six months. Prices rallied in August and again in October-November, but the XLF got stuck in the $35-$36 area for about three weeks, and now we are likely to close below that zone…The risk is that everyone who went long the XLF in the past three weeks will be at a loss or "underwater," and this condition is likely to precipitate further declines. Prices are still above the popular moving averages, but the slope of the 200-day line is still negative. The trading volume has diminished since the middle of October…The Moving Average Convergence Divergence (MACD) oscillator has crossed to the downside for a take profit sell signal.”

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The weakening in financials hasn’t been lost on Real Money Pro’s Doug Kass, a former bull on the sector who has recently been opportunistically shorting the basket. He wrote in his trading diary:

“I would look for caution by bank managements reflecting an erosion in the prospects for global economic growth, some evidence of degradation in credit - specifically risks associated with leveraged loans - a weakening in the consumer, a hellacious decline in mortgage activity, an acceleration in bank deposit outflows, an increasingly difficult trading backdrop and some caution on Net Interest Income stemming from outflows…Reflecting some of my concerns, I recently materially reduced my exposure to money center banks and to selected financials.”

Also, technology stocks – typically big winners in the early stage of the business cycle – have underperformed the Dow Jones Industrial Average, arguably the most staid index. Since the lows in October, the SPDR Technology ETF  (XLK)  is up 15% versus 18% for the Dow Jones ETF. That’s not the kind of performance you’d necessarily expect in a risk-on, buy-stocks market.

Worrisome economic news remains

The technicals suggest the risk of lower stock prices has increased. We certainly saw that yesterday, given 90% of trading volume was on the downside. It would be a good sign if we mount a rally off these support levels. However, economic and profit data remains a headwind.

Last week, the Federal Reserve hinted it’s open to smaller rate hikes but that rates would still head higher and stay there longer than some hope. Unfortunately, core Personal Consumption Expenditures inflation at 5%, well above the Fed’s 2% target, and stubbornly low unemployment data likely did little to shift that thinking.

The negative impact of higher rates lags, but the evidence is mounting that the economy is stuttering. Manufacturing activity is contracting, and discretionary spending is shifting toward essentials, given personal savings are back to levels last seen in the 2000s, and credit card debt has skyrocketed to a record. Unemployment levels may not reflect it yet, but a growing pace of layoffs suggests that could change in the coming months.

Corporate operating margins are thinning as the ability to pass along higher costs shrinks alongside demand. As a result, analysts are significantly (finally) ratcheting back earnings outlooks. In Q4, the S&P 500 companies are expected to see earnings decline 2.4% from one year ago. In the first and second quarters of 2023, EPS is expected to improve by just 1.5% and 0.8%, and those figures are falling following recently reported and lackluster third-quarter results. For instance, according to FactSet, the full-year 2023 EPS outlook fell 3.6% to $232.52 between September 30 and November 30.

The drop in forward earnings is problematic because it’s pressuring the “E” in P/E ratios while “P” has risen. Using FactSet's estimate, the S&P 500’s forward P/E is 17.6, up from 15.2 on September 30.

FactSet’s estimate may be too optimistic still, though. J.P. Morgan reduced its EPS outlook by 9% to $205 last week, while Morgan Stanley clocks in with a $195 estimate.

The Smart Play

Stocks are at a crossroads, with many investors on the sidelines waiting for a new uptrend or downtrend to establish itself before committing capital. If stocks can hold and build, it would mark a change of character, given overbought signals this year have coincided with selling. Therefore, bulls will want to see a break out decisively above the 200-DMA soon.

If we fail to hold support, though, stocks could cascade lower quickly as many who have FOMO’d into the basket over the past month hit the sell button rather than risk a return to October’s low.

Given the uncertainty, active investors should consider raising cash again by booking profits or selling broken stocks with a busted thesis that recently rallied. At a minimum, the current situation suggests that stop losses be implemented to protect against the downside.

Longer-term individual stock investors can take a sit-on-hands approach. If stocks do hold and build, there will be plenty of opportunities to buy with better risk-reward, and if they fail and roll, you’ll likely get better entry prices by waiting. 

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