On April 8, I sent out a Special Update reiterating my view expressed in the March letter that "the market is likely close to a short term high, and vulnerable to a pullback of 4% to 7% in coming weeks. Selling into any additional strength, or becoming a bit more defensive is advised." In my April 20 letter I discussed the internal dynamics at work in the market. "Normally, technicians view rising volume on a sell off as a negative, but that hasn't been the case, as the market subsequently rallied to new highs after the declines in early October and November. I think the increase in volume now is an indication that investors are finally convinced this rally is for real, and as such, is a sign of optimism and a short term top. The market should get above the high at 1,214 to finish the rally phase that began on February
5. Last week, more than 900 stocks made new 52 week highs, the advance"decline line also set a new high, and the majority of market averages set new peaks. This indicates that the market's internal strength is healthy, which is why any decline is unlikely to exceed 4% to 7%. This broad market strength also suggests that any decline will be followed by another rally that challenges or exceeds the high I expect soon. The major trend is up, and will remain positive as long as the S&P holds above 1,044. The intermediate trend is positive as long as the S&P remains above 1,086." The S&P did exceed 1,214 on April 26 when it reached 1,219.80.
The fact the anticipated decline has turned out to more severe than 4% to 7%, only makes the advice to sell and become more defensive above 1,210 more valuable. The internal strength cited in last month's letter has obviously weakened. On May 20, there were 18 times as many declines as advances, an extreme level, and the number of new lows has expanded significantly. The chart above shows the S&P with the Intermediate Trend indicator (IT), a proprietary indicator I use to measure short term and Intermediate term strength in the market. It combines advances, declines, new highs, new lows, up volume and down volume into a single indicator. In the April 8 Special Update I noted that while the S&P was making a new high, the IT was registering a lower peak. This indicated that the market's internal strength was weaker, even though the S&P was making a new high. This pattern of higher prices and lower IT readings suggested the market was vulnerable to a sell off. Today, the S&P tested the February low of 1,044, falling to 1,040.78, before rebounding to 1,074. Although the S&P held support, the IT has dipped below the February 5 low.
The intensity of this sell off lowers the odds that the market can rebound to a new high. So far, the decline has only 3 legs, down, up, down. If today's low is breached, the odds of a new high will be further reduced. I believe the market is in a cyclical rally within the context of a secular bear market that could last until 2014"2016. As noted last month, I anticipate another decline of 20% to 30% developing, if the fundamental headwinds exact the economic toll I expect. Last December, I discussed why I thought the next phase of the financial crisis was likely to start in Europe, since their banks were more leveraged and more exposed to Greece. A decline below today's low, will likely lead to a sharp drop to 980"1,020. However, the market should then rally and retrace a sizable portion of the decline from the April 26 high at 1,219. If the market has plans on approaching the April peak, the liquidity squeeze that has erupted over the last two weeks in Europe must calm down. The market is oversold, so a short term low is approaching. The next few weeks should clarify, whether the secular bear market has resumed, or if there is still some life left in the cyclical bull that began in March 2009.
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