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  • Stocks have rallied nicely since June 17.
  • Major market indexes are entering resistance and sentiment is no longer oversold.
  • A possible "Chop-fest" means shorter-term investors can take some chips off the table and tighten their stops.

Stocks have bounced nicely since the S&P 500 made its low amid horrible sentiment earlier this month. The S&P 500, NASDAQ 100, and the Russell 2000 have rallied 6.7%, 6.6%, and 6.8%, respectively, since the S&P 500’s low on June 17.

If that sounds familiar, it should. The S&P 500 has had a bear market bounce greater than 7% every month this year except in April when it carved out a 3.3% gain. Recently, I wrote this means you should treat this current rally as if it was from the “show-me” state. Certainly, stocks could continue higher, but Lucy's pulled the ball from Charlie enough times this year to make being suspicious wise.

How much higher could stocks go? The charts offer some clues.

In “What's the 'Pain Trade' Now?”, Top Stocks Helene Meisler updates members on her view of how much gas may be left in the market's tank.

She writes, “two weeks ago the pain trade was for the market to rally. So, it did. And we've seen that slight shift toward more bulls…But here's the question: We are now just over a week into the rally and according to my work we ought to be back to an overbought condition late this week or early next week, so what is the pain trade now?”

At inflection points, the market punishes the masses. When everyone’s bearish, it rallies. When everyone's bullish, it falls. Rinse and repeat. It's for this reason that many market watchers focus on sentiment indicators for clues to determining if stocks are short-term overbought or oversold. In mid-June, stocks were oversold. Now? They’re at risk of becoming overbought again, even as major market indexes test resistance at their 50-day moving averages.

Back to Meisler:

“Let's look at the chart of Russell fund  (IWM)  to see if there are any clues. I have put the still-declining 50-day moving average on this chart, because you can see that since November every rally to this moving average line has been rejected, with the exception of late March/early April.

My math says that by the end of this week/early next week (about a week from now) the moving average ought to be around $180. My inclination, because of the upcoming overbought reading, is that somewhere between $180-$185 we see resistance. So it's possible we cross the moving average line, convert more bears to bulls and that's that.”

CHART-Street-Smarts_2__062822

So, we're approaching a declining 50-DMA (and FWIW, a declining 21-DMA and 200-DMA). If it can recapture this level, it could be bullish. However, we've already seen examples of an index recovering its MA this year only to slice back down through it. For instance, the S&P 500 ETF  (SPY)  recovered its 200-DMA in January before rolling to a new low. Then, it did that again in March. The Russell 2000 slightly eclipsed its 200-DMA in December, and briefly recovered its 50-DMA in March, before falling to new lows.

The situation is similar for the NASDAQ. Meisler writes: “The  (QQQ)  has the same issue: A declining 50-day moving average line that has stopped all rallies outside the March one and resistance overhead.”

The fact we’re nearly back to levels where trapped sellers may say “phew, I can get out flat” is particularly worrisome because Meisler’s indicators are also mapping a path to overbought soon. Meisler writes, “We ought to be back to an overbought condition late this week or early next week,” on her short-term oscillator; and in “Will the Russell Show Some Muscle?,” she writes, “The 30-day moving average of the advance/decline line is now a little bit overbought.”

The combination of a short-term move that’s getting a little bit over its skies and a market that's approaching resistance has Meisler thinking the coming weeks may be a “chop-fest” that makes nobody happy.

Back to Meisler:

Here's my guess. We don't do an immediate rollover from the overbought condition. We do a giant chop-fest. That giant chop-fest helps convert some of those bears to bulls. That giant chop-fest gets the 10-day moving average of the put/call ratio to fall. That giant chop-fest gets the 10-day moving average of stocks making new lows to fall. That chop-fest has scary down days. That chop-fest has feel-good up days. And that is the pain trade, where no one feels good for more than a day or two. Everyone feels uncomfortable. We all feel like we've got whiplash.”

The Smart Play

The ‘easy’ money off the low was made because sentiment screamed folks were ready to cover shorts. The tough money, however, depends on institutional buyers continuing the momentum that short covering started. Unfortunately, that could be a tough ask given that quarter-end statements may cause a wave of redemptions at mutual funds and hedge funds (the S&P 500 is down nearly 14% in Q2, despite the recent rally).

July is 'usually' a solid month for stocks. According to the Stock Trader’s Almanac, it’s the fourth-best month of the year for the S&P 500, generating a 1.1% average return since 1950. However, stock performance is mixed in mid-term election years. The S&P 500 still ekes out a 0.9% average return in July in midterm years, but the Nasdaq loses 1.9% and the Russell 2000 loses 3.8% in the month during mid-term election years. That’s hardly encouraging to bulls.

If Meisler’s “nobody wins” market outlook proves correct,  staying defensive and patient is wise. There will be plenty of time to make money with a better risk-to-reward ratio once a trend is established. Sure, you can carve out some gains in a chop-fest, but those gains may be fleeting because timing needs to be impeccable. That’s a risk most investors shouldn’t take.

In "If You Buy Now in This Bear-Bull Battle, You May Be Paying Later," Action Alerts PLUS' Bob Lang sums this point up, writing "Unless the price action confirms the indicators, however, you can't jump ahead. Yet, that seems to be the modus operandi these days. Anticipate, estimate and guess the direction. What happens after the directional bet? We get slaughtered."

Therefore, if you’re a shorter-term or intermediate-term investor, recognize we don’t have the sentiment indicators support as we did in mid-June, and we face a tougher hill to climb now that we’re into resistance. Therefore, taking some profit off the table to reduce exposure and using trailing stop losses until there’s more clarity is prudent.

If you’re a long-term investor, the advice remains the same. By now, you’ve already increased your dollar-cost averaging contributions to an index fund so that you’ll own more shares at a lower average cost when the bulls regain the field. It may be a while before that happens, but there’s never been a bear market when long-term investors haven’t (eventually) been rewarded for dollar-cost averaging into the S&P 500 during a bear market. 

  • Stocks have rallied nicely since June 17.
  • Major market indexes are entering resistance and sentiment is no longer oversold.
  • A possible "Chop-fest" means shorter-term investors can take some chips off the table and tighten their stops.
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