It has been a wild ride in the stock markets over the last couple of months, but the extreme fear we experienced for a brief time now appears to have abated somewhat, and Friday’s move from the lows felt very much like bear capitulation with a rally now underway. However, while the short term looks bright, in broad strokes the stock market remains fragile and there are a number of yellow flags waving in terms of the technical picture, with a couple of red ones flashing too.

2015 was the first year ending in a ‘5’ not to give us a positive return in the history of the S&P500. Although this may sound like a minor niggle I would disagree, as seasonality plays a large role in terms of investor confidence, and disruption to that rhythm does tend to have a knock on effect. If the cyclical pattern has been disrupted, how do we know they will revert back to normal in the coming months? For example, if the oft quoted ‘sell in may and go away’ does not work in one year and instead we rally hard through the summer months, would investors still want to put money to work in November in keeping with seasonality? Certainly there would be more cause for pause in my opinion.

The second red flag is the 5 month moving average closing below the 20 month moving average in December, and this one is more serious given that the signal is rare. Since 1991 there have been only 5 crosses of these averages, and all of them led to out-sized moves in the stock market. The monthly chart below gives you the buy/sell signals and as you can see they marked the tech bubble top of 2001 and the credit crisis top of 2008.

Looking at the indicators, MACD is pointing straight down and momentum as illustrated by William %R is weak. Additionally we now have a lower high and a lower low in the daily chart, and we therefore have a burgeoning downtrend in place. Should we fail to make new highs from here and start to turn lower there would be the very real risk of a big move to the downside, with primary support in the 1550-1700 range and a chance to hit 1400 SPX.

Looking at our yellow flags we have earnings per share and revenue growth declining, corporate debt to earnings at new 12 year highs (although this may just be companies taking advantage of the low interest rate environment), IPOs failing in large numbers, Margin debt declining for 6 months in a row, and short interest (as a percentage of the float) in SPX elevated at 4.4% which is in line with 2011 readings. Not a pretty picture at all.  

 In the short term however, there is a very good chance for a decent move higher, and the technical picture on the daily timeframe looks a lot healthier than it did a week or two ago. Breadth is starting to improve from washout levels, and many stocks are starting to turn the corner for a counter trend rally. The percentage of companies trading above their 50 day moving average has risen to 29.08%, and those above their 200 day moving average has climbed to 29.14% from very low levels last week. With the 5 year average being 58% and 67% respectively, and the percentage of stocks in overbought territory being only 1.2%, there is real scope for a move higher.

From a trading perspective I am already long the S&P500, but will be looking to add on any dip we see at the start of the trading week. In terms of the SPY ETF support comes in at around 191, and assuming we see that level hold and a rally take place I am targeting the 197-200 resistance range first, followed by the 204-208 range should we manage to clear that first resistance zone and consolidate above it.

I wish you all good luck for the coming week!