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  • Stocks have climbed over 10% since the mid-October lows.
  • Investor pessimism is shifting toward optimism.
  • Major stock indexes are challenging resistance at the 50-day moving average.
  • The Dollar's retreat has supported stocks, but it will test support soon.
  • The Bond rally has driven yields lower, but resistance is approaching.

The S&P 500 and technology-heavy NASDAQ 100 are up over 11% from their 52-week lows on the 13th, one day before I wrote that “selling the market now to buy it back cheaper sounds good in theory, but oftentimes the best long-term returns come from sitting tight through thick and thin.” 

Those who avoided getting shaken out earlier this month benefited nicely. Especially,  since the Invesco DB US Dollar ETF  (UUP)  rolled over last Friday and Treasury bond yields declined this week. Combined, the two took a foot off the brake on stocks, allowing them to move higher, a possibility we discussed last Thursday and Friday.

However, the rally has been rapid, and stocks don't rise or fall in a straight line. It wouldn’t be shocking if, at a minimum, stocks take a breather. After all, extreme pessimism foreshadowed the move, but investors are becoming optimistic again, so support from bearish sentiment is waning.

Sentiment isn’t as lousy as it was earlier this month

On Tuesday, Top Stocks’ technical expert Helene Meisler pointed out that her short-term advance/decline oscillator and the McClellan Oscillator were shifting to overbought from oversold. She wrote:

“First of all, from yesterday, we already know that we were heading into a short-term overbought reading in the latter part of the week, so a pullback is not out of the question. You can see it much more clearly on the chart of the Overbought/Oversold Oscillator today. Yesterday the Oscillator was peaking over the zero line. It is now solidly there…the McClellan Summation Index is rising. It needs a net differential of -4,000 advancers minus decliners on the NYSE to halt the rise. That's a good cushion, but it's also what makes it short-term overbought…unless you believe this low is like 2020 (I do not), then 2022 might be a better guide. Point A was in late March 2022. We did in fact rally another week or two before the market rolled over…Point B was late May, and we milled around at the top of the rally for a few days, but again, we rolled over. Point C occurred in late July/early August, and we rallied for about another week or so before rolling over.”

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Meisler also wrote, “My real issue with this market is that it seems to me sentiment has gotten too bullish too quickly. Perhaps the earnings news and a pullback will help that situation, but when the S&P 500 is up 10%, and everyone starts jumping on the rally bandwagon -- after we're up that much -- I get concerned.”

Meisler isn’t the only one to think the rally may pause. In his daily trading diary today, Real Money Pro’s Doug Kass expressed some concern too. He wrote:

“I have substantially increased my cash position and reduced my net long exposure…I have sold my entire (SPY) long position at $385.55.” He also wrote, “While I have been more bullish - and I have documented why in my Diary - than many in the last month, I am increasingly concerned about the rising tide of optimism - in some cases coming from previously self-confident bears…As far as I can see, the prevailing view seems to be based on two factors:

* The current price momentum

* Expectations of seasonal strength over the next two months

While there are numerous reasons to be constructive, to this observer, these two factors are not rigorous reasons to become bullish…In fact, they are poor reasons and a dangerous/slippery slope to become bullish.”

More reasons to worry stocks could stall

The market is also near a critical point where trapped sellers may use strength to sell, and short-term traders who made fast money may lock in profit, given the S&P 500 is challenging resistance at its downward-sloping 50-day moving average. Stocks could certainly move above this line as they did in July, but they could also stall out and trade lower as they did in early September.

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The slide in the Dollar has helped stocks, but support is approaching. 

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Moreover, the rally in Treasuries that’s forced yields lower has been strongest at the long end of the curve. Thus, the 10-year/3-month Treasury yield curve joined the 10-year/2-year curve, inverting for the first time this year.

As Real Money’s Stephen Guilfoyle reminded investors in Morning Recon today, “the San Francisco Fed has acknowledged an inversion of this particular spread (not the 10 yr/2 yr) as the most accurate predictor of economic recession at the Fed's disposal.”

Tomorrow we’ll get the official third-quarter GDP figure. It’s likely to show growth returned following two negative GDP quarters to begin the year. However, the 10-year/3-month inversion suggests that the bump up could be short-lived if its ability in the past to predict recession repeats.

We’ll also get what’s likely to be yet another “too hot to handle” inflation report on Friday. 

The Cleveland Fed’s Nowcasting tool estimates headline PCE and core PCE, ex-food and energy, climbed 0.33% and 0.44% in September, respectively, bringing year-over-year headline and core inflation to 6.27% and 5.16%. For perspective, in August, the headline and core numbers were 6.2% and 4.9%. Remember, it's the Core PCE that the Fed’s trying to wrestle lower. Despite its hawkish rate hikes, core inflation has yet to show it’s rolled over.

The Smart Play

Could we wind up with slugflation or stagflation? If so, will we get one more risk-off trade where stocks are sold to buy bonds to benefit from juicy short-term rates? I suspect that’s what the debate will be from here.

Further out, inflation comparisons get easier next year, so if prices remain similar to where they are currently, the Federal Reserve could justify shifting to a “wait-and-see” approach. For now, however, the CME’s FedWatch tool shows the Fed will increase by yet another 0.75% next week, followed by another 0.25% to 0.75% increase in mid-December.

The US Dollar Index has dipped below 110, slightly below its 50-day moving average. Real Money Pro’s Carley Garner correctly laid out the argument for a Dollar slide and thinks $105 is strong support. So, if the Dollar keeps heading lower to 105, stocks benefit. However, stocks could lose some luster if it starts to find some footing, even if temporarily, between here and there.

Given indicators and events supporting the rally aren’t flashing “buy” as brightly as they were, active investors should consider locking in profits on recent gains and moving up stop losses to below the 21-day moving average. If we continue higher, you'll still have some exposure, but if we roll over, you'll have employed solid risk control.

It could also be a good time for investors trapped in stocks to sell them into strength, freeing up cash. 

Remember, the big winners in the next bull market aren’t likely to be the same as the last bull market, so don’t let your ego prevent you from shifting away from stocks where your thesis has broken.

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