Market Timing Model Update – Pullbacks are our Friends – Here’s What to Watch

The recent breakouts and new highs in several key index, sector and industry group ETFs are bullish for the broader market. Now that we have the “all clear” for stocks, perhaps we should prepare for a pullback. Today I will review the long-term bullish evidence and then show some short-term indicators to watch in the coming days and weeks. The short-term trend is clearly up, but some indicators show narrowing participation within the S&P 500.

Breakouts, Targets and Pullbacks

The S&P 500 SPDR (SPY) broke out of an Ascending Triangle last week and hit another new high this week. According to classical technical analysis, the height of the pattern is added to the breakout for an upside target. With the pattern measuring around 20 points and the breakout near 302, this implies further gains to the 322 area (+4.5% from current levels). Take this target with a grain of salt because it is not the most important aspect of this chart. The overall trend is what truly matters. This includes the higher highs, higher lows, price above the 40-week SMA and positive PPO(4,40,0).

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The long-term trend is up and a fresh new high is bullish, but this does not mean SPY will get to its price target in a straight line. Even though it could, I would be more inclined to expect a consolidation or even a throwback to the breakout zone before continuing higher. Heck, SPY could even move back below 300 and this would still be a normal pullback considering the prior advance. Don’t fall for the “failed breakout” chorus. Pullbacks are our friends and I would consider a pullback to the 298 area as an opportunity, not a threat.

Breakouts, Targets and Pullbacks

The Index Breadth Model improved as S&P 400 MidCap High-Low% ($MIDHLP) moved above +10% to trigger a bullish signal on Tuesday and reverse the prior bearish signal. S&P 600 SmallCap High-Low% ($SMLHLP) is now the only one of the nine indicators with an active bearish signal. All told, table confirms the bull market environment because eight of the nine indicators are on bullish signals.

The S&P 500 remains the strongest of the group because its indicators have been net bullish since early February. The small and mid cap indicators whipsawed from May to August, and this caused the table as a whole to flip (bullish, bearish, bullish, bearish, bullish). The most recent net bullish signal started on September 5th and remains in play.   

Indicators to Watch for a Short-term Reversal

Even though we are in a bull market environment, stocks are extended after a big move the last 5-6 weeks and ripe for a rest or pullback. Frank Cappelleri of Instinet (@FrankCappelleri) tweeted out some stats noting the longest streaks when the S&P 500 traded within a 1% or less intraday range. This tweet got me thinking about the 1-day Rate-of-Change and 2-day Average True Range (ATR). These two indicators measure volatility in a way and they are showing relatively low volatility over the last three weeks, and counting. Low volatility is good for a short-term advance, but an upturn in volatility could signal a short-term reversal and the beginning of a pullback.

The green zones show when the 1-day Rate-of-Change did not go below -1% for an extended period (3 or more weeks), The red vertical lines show when the 1-day ROC exceeded -1%. In the second indicator window, 2-Day ATR moved below 30 as the low volatility advances extended. Subsequent moves above 30 showed an increase in volatility. Taken together, a move above 30 in ATR(2) and below -1% in ROC(1) would signal an increase in volatility and argue for a pullback in the S&P 500.  

There are two other indicators that undermine the short-term advance. Note that these indicators are by no means medium-term or long-term problems. They just point to a narrowing advance over the last few weeks and this could give way to a pullback. Also note that the S&P 500 is up 6.5% over the last 27 days.

The first indicator shows Advance-Decline Percent for the S&P 500, S&P 400 MidCap Index and S&P 600 SmallCap Index. I am focused on the S&P 500 because it is the main driver of the stock market. Notice that Advance-Decline Percent weakened over the last few weeks and has not exceeded +50% since October 21st, three weeks ago. This was before the index hit a new high. Thus, the move to new highs was on pretty weak breadth.

The second indicator shows the percentage of stocks above the 20-day EMA. I normally use this indicator to identify short-term oversold conditions (<20%) and a subsequent upturn (>50%). This time I noticed that S&P 500 %Above 20-day EMA ($GT20SPX) stalled out around 73% and did not exceed 80% on the latest advance. Conversely, this indicator exceeded 80% during advances in January, February, April, June and September. The inability to exceed 80% now shows less participation at new highs. A move below 50% would tilt the short-term balance from bullish to bearish. Again, this is not a call for a bear market. It is a short-term issue that could foreshadow a pullback.

Small-caps Not Quite Outperforming

The Index Breadth Model shows small-caps underperforming and this is also reflected on the price charts. The small-cap ETFs, IWM and IJR, are up more than SPY over the last 26 days, but they are still lagging on the three, six and nine month timeframes.

The chart below shows the Russell 1000 ETF (IWB), Russell 2000 ETF (IWM) and Russell Microcap ETF (IWC) for another take on the performance differences among market cap segments. I prefer to compare peaks and troughs to measure relative chart performance. The blue shading show where IWB formed an equal low in early June and a higher high in July. IWM and IWC, in contrast, forged lower lows in early June and peaked below their prior highs in July. This is relative chart weakness.

Looking at recent price action, we can see all three ETFs with higher lows from late August to early October. Small-caps and micro-caps finally held up as well as large-caps. IWB has since moved to a new high, while IWM exceeded its mid September high (but not its May or August highs). IWC has yet to exceed its mid September high. IWB is still the strongest of the three because it is the only to exceed its July and April highs.

Sector Breadth Model Remains Firmly Bullish

There is no change in the Sector Breadth Model and it remains firmly bullish. Ten of the eleven sectors are net bullish with Energy being the only bearish sector. The five offensive sectors are net bullish, as is the Healthcare sector. Technology and Healthcare have been net bullish since February 1st, while Finance and Consumer Discretionary have been net bullish since early September. Communication Services whipsawed a bit and has been net bullish since late October. Even without Communication Services, five of the big six sectors are firmly bullish and this is more than enough to support a bull market.

New Highs Surge in Finance and Industrials

The next chart shows the High-Low Percent indicators for the six biggest sectors. High-Low Percent equals new highs less new lows divided by total issues. The green ovals show when High-Low Percent “popped” for each sector. Technology and Communication Services experienced a new high pop in early September, Consumer Discretionary popped in mid October and Healthcare had a feeble pop at the end of October.

Most recently, the Industrials and Finance sectors experienced big pops as High-Low Percent exceeded +30% for each sector at some point this week. There are over 60 stocks in these sectors and this means over 20 stocks in each sector hit new highs. A stock hitting a 52-week high is in a strong uptrend and this shows broad leadership within the sectors. This is also bullish for the broader market.  

Fed Balance Sheet Continues Expansion

The Fed balance sheet continued its expansion and is now above $4 trillion, its highest level since January. This is the ninth consecutive increase in the balance sheet. The middle window shows the System Open Market Account (SOMA) increasing sharply the last three weeks and rising six of the last nine weeks. Whatever you think about Fed policy, an expanding balance sheet is positive for stocks and I do not want to fight the Fed.

This chart does not have a link because it contains user-defined indexes.

Bottom Line

The bulk of the evidence remains bullish for stocks and the advance appears to be broadening as more sectors and industry groups hit new highs. Even though this is positive when looking out two to six months, stocks are getting quite extended short-term. SPY, QQQ and IWM are up six to nine percent over the last 5-6 weeks, while XLK, XLI and XLF are up nine to eleven percent. These are big moves that could give way to a consolidation or pullback. I will be watching the 1-day ROC and the 2-day ATR for the S&P 500, as well as the S&P 500 %Above 20-day EMA for indications of a short-term reversal.

-Arthur Hill, CMT
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