Curb Your Enthusiasm

In July the rally was over. Everybody knew it. The S&P 500 had formed a bearish head and shoulders pattern on the daily chart and had fallen through the neck line. The March lows were up next.

And then it didn’t happen.

Instead we got a furious rally that extended 7% into new high ground on the NASDAQ and better than 6% on the S&P. For the first time market participants became convinced they were in a bull market.

Then in August the indices broke lower. But volume was light and bulls stepped in immediately to stanch the bleeding. The indices shortly broke to new highs. Investors were now confident of an enduring bull.

Just when investors were feeling invulnerable the market very quickly corrected again after making little progress into new high ground. But once again the indices found their footing and moved to new highs by 5% on the NASDAQ and nearly 4% on the S&P.

Almost routinely the correction in the second half of September was scooped up by investors. Yet this time the markets made even less headway into new high ground: just 1% on the NASDAQ and under 2% on the S&P.

October’s correction featured the NASDAQ undercutting a prior low, usually a late confirmation of a more significant correction set to unfold. But rather than succumb the indices again bounced back. This time the gains into new high ground were about ½% on the NASDAQ and 1% on the S&P.

And while the indices increasingly sputter on every move to new highs negative divergences abound. The narrowing of 52 week highs is our favorite, easy to gauge indicator. The breakdown of formerly leading stocks and cautionary signs given off by others is more subtle but cannot be ignored.

The latest casualty is Green Mountain Coffee Roasters (GMCR), a mid-cap that more than trebled during the bull market. It's fallen hard under its 50 MA, a key level for stocks in uptrends. Meantime Apple (AAPL) and Baidu (BIDU), two major institutional favorites of the rally, have potentially put in double tops that sport unfavorable volume profiles and appear vulnerable.

We still believe the markets will continue higher until the liquidity punchbowl is withdrawn by The Fed. According to the OECD in a release out this morning that might not be until late 2010.

But that doesn’t mean a more severe correction won’t be in the offing. The markets have avoided that to date and new bulls can go a year or more without a correction of 10% or greater. But we can hear the indices groan with every uptick each time they enter new high ground. Clearly the upside is limited for the moment. It might be time to take a step back and curb your enthusiasm.