Monday, April 4, 2011

Getting ready to sell in May?

The economic headlines look good. Last Friday we saw the US Non-Farm Payroll report came in ahead of expectations and China's PMI rose indicating continuing growth. Stock markets rallied on the news.

With major equity indices approaching an important resistance level...

and the small cap Russell 2000 already in a healthy relative uptrend and breaking out to new highs relative to the market, is it time to sound the all-clear for the bull trade?

Some caution flags
Before the bulls uncork the champagne, I would urge caution on a number of fronts. First of all, the end of QE2 is just around the corner. Given the growing slew of positive economic indicators, a growing chorus of Fed governors discussing how the Fed should tighten and discussions of QE2 exit strategies, there will be no QE3 in July. So what happens to the equity markets when the stimulus of QE2, which is designed to buoy asset prices, is removed?

Indeed, some of the secondary indicators that I have been watching are starting to roll over, likely in anticipation of the end of QE2. For instance, despite the continued strength in commodity prices, Dr. Copper is not showing signs of strength as it has broken down from an uptrend and is now showing signs of a minor downtrend.

There are other signs that not all is right with the markets. Energy has been the recent leadership, as shown by the relative chart below.

...but the Oil Service stocks, which usually show a high energy beta and should be sprinting ahead in this energy rally, are weak when compared to the Energy sector:

Another example can be found in the cyclically sensitive semiconductor group, which is breaking down on a relative basis. (If the economic news is pointing up, then why are cyclicals like the semiconductors behaving badly?)

What's more, heavyweights like the Financials aren't behaving terribly well against the market.

Looking ahead, after the oversold rally
I wrote back on March 21 that we are poised for an oversold rally that is likely to last at least two weeks. Two weeks have passed and the markets have rallied. Today, secondary indicators are showing worrisome negative divergences. While this doesn't mean that equities go down right away, but these are signs that the risk-reward tradeoff is becoming increasingly unfavorable.

For now, the asset Inflation Deflation Timer Model remains at the high-beta asset inflation reading. While I am cautious, I am not in bear mode as these conditions can allow these market tensions to resolve themselves through a sideways consoldation pattern.

Nevertheless, the prospect of selling in May and going away is starting to sound good right now.

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