Why Stocks Could Be Forming A Top, Despite The S&P 500 Breakout

Last week, I penned a blog post that suggested stocks were headed lower due to seemingly bearish volume patterns in the NASDAQ Composite.

Since then, the major indices have been moving steadily higher instead, with the S&P 500 index gapping to a fresh all-time high on May 27.

Not surprisingly, stocks moving up while I suggested the possibility of them moving down led to an assortment of emails from readers who were quick to point out how “wrong” my analysis was.

But here’s the amusing irony of the situation.

The act of suggesting I am “wrong” because the stock market has not yet fallen apart is actually wrong because…

Market Topping Is A Process, Not An Event

With the exception of monumental, one-day market crashes that happen once in a blue moon, bull markets that are topping undergo a drawn-out process that usually takes at least several months before bearish momentum finally takes over and a new downtrend emerges.

The longer the bull market has been in place, the more it tries to stand its ground by kicking and screaming.

Considering that US stocks have been in a 5-year bull market, it would be unreasonable to expect such bullish momentum to change overnight.

Therefore, even though price momentum has been favoring the bulls lately, I maintain my stance that it is dangerous to be heavily invested on the long side of the market right now.

Furthermore, I continue to believe equities (particularly NASDAQ stocks) are headed considerably lower in the near to intermediate-term.

As always, this objective assessment is based on what I see, NOT what I think!

And right now, I plainly see…

4 Key Warning Signs For Savvy Traders

If you are a skilled daytrader who is quickly in and out of the market every day, you’re probably not very concerned about major stock market trends and can therefore ignore the rest of this article.

But if you are a swing trader or position trader who thrives on trend following (like me), you should at least be aware of 4 reasons why I feel a high level of caution is presently required on the long side of the market.

1.) Strong Long Bond

In the May 28 issue of my Wagner Daily newsletter, I said, “Are institutions running from the stock market and into bonds? After an ugly 1.5 year selloff, $TLT (iShares 20+ Year Treasury Bond ETF) has put in a bullish trend reversal, with the 10-week MA crossing above the 40-week MA back in March.”

Take a look at the daily chart of $TLT below:

Because government treasury bonds are usually considered to be a defensive “safe haven” to stash funds in weak equity markets, there is frequently an inverse correlation between stock and bond prices.

Obviously, this inverse price correlation between stocks and bonds is not always present.

However, it is indeed extremely rare is for stocks and bonds to simultaneously be trading at or near 52-week highs.

Other astute traders are also apparently intrigued by this situation, such as well-known Twitter trader @ivanhoff, who subsequently tweeted the following:

When was the last time when both US Treasuries and the S & P 500 were at 52-week highs? We’re almost there. $TLT $SPY

— ivanhoff (@ivanhoff) May 28, 2014

Thankful for not keeping me in suspense for too long and saving me a bit of research time, @ivanhoff followed up with this tweet:

The last time US Treasuries and the $SPX were making new 52wk highs together was in the mid 90s. https://t.co/8WagMzoBRd — ivanhoff (@ivanhoff) May 28, 2014

While this curious situation of simultaneous strength in stocks and bonds could continue indefinitely (always remember anything is possible in the stock market), I personally believe the substantial money flow into bonds is the result of banks, mutual funds, hedge funds, and other institutions decreasing their equity exposure, perhaps as a precursor to a serious sell-off in the coming weeks/months.

2.) NASDAQ Head & Shoulders

In my April 28 blog post, I pointed out the bearish head and shoulders chart pattern that was forming in $QQQ (NASDAQ 100 ETF).

Fast forwarding to one month later, $QQQ has grinded all the way back to test the “head” of the chart pattern, thereby decreasing the odds of the bearish pattern following through to the downside (but now creating the possibility of a double top being formed).

Further, it’s important to note the broader-based NASDAQ Composite Index has been showing relative weakness to its large-cap brother, the NASDAQ 100 Index.

As such, the NASDAQ Composite is only just now forming the “right shoulder” of a head and shoulders topping pattern:

On May 27, the NASDAQ Composite jumped 1.2%, but that rally put the index right at key resistance of the top of the “left shoulder” shown on the topping pattern that is in play on the chart above.

For this bearish pattern to remain intact, the price action should not run too far above the high of the left shoulder before reversing back down (click here to learn more nuances of the most reliable head and shoulders patterns).

A move to the 4,300 level (above the high of the left shoulder) would be excessive and would probably kill the pattern.

However, even if the NASDAQ is able to push through the high of the left shoulder and thereby invalidate the head and shoulders pattern, a double top type of pattern would then be in play (as with $QQQ at the moment).

3.) Bouncing Up, Not Breaking Out

One major concern is there continues to be a lack of high quality growth stocks breaking out to new highs.

Rather, many are simply just now bouncing off support of their 50-day moving averages.

One such example can be found on the daily chart of Michael Kors ($KORS) below:

After reporting pre-market earnings on May 28, $KORS actually demonstrated bullish price action by reversing a steep opening loss and closing in positive territory.

Nevertheless, the stock still must contend with an abundance of overhead resistance because it is merely bouncing off support of its (downward sloping) 50-day moving average and prior downtrend line. as opposed to breaking out to a new high.

4.) Wimpy S&P 500 Breakout

Finally, I find it negative that the May 27 breakout to a new record high in the S&P 500 occurred on volume that was approximately 30% lighter than average.

On the chart of S&P 500 SPDR ($SPY) below, you can see the light volume of the breakout by comparing the day’s volume with the green line at the bottom (50-day average volume):

The best stock breakouts are accompanied by volume spikes in which that day’s turnover swells to several hundred percent of its 50-day average volume level.

Therefore, I view it as a warning sign that volume could not even exceed the 50-day average level, despite the price of the S&P 500 jumping to an all-time high.

When a stock or index is trading at a new high, a complete lack of overhead supply means it does not require much volume for the stock or index to continue moving higher.

However, if the breakout occurred on measly volume, it only takes one bout of institutional selling for the breakout to fail because supply would easily overwhelm demand if breakout volume was light.

No Harm, No Foul

If you have been following my blog and reading my moderately bearish analysis of the past several months, you may be under the impression I’ve been selling short everything under the sun (and correspondingly suffering losses).

If that’s you, it’s okay. I forgive you. But you are actually wrong.

As explained in this May 12 blog post, the model portfolio of my nightly stock and ETF picking newsletter (which is less than $2 per day based on annual rate) has largely been positioned in cash due to choppy market conditions (capital preservation mode).

Since my trading strategy requires the presence of price confirmation before acting on any chart patterns (bearish OR bullish), I have not yet shifted into a bearish short selling mode because prices have yet to confirm my bearish analysis.

Although I am fully prepared to start making short selling profits IF the market convincingly breaks down, I am equally prepared to bang out gains on the long side of the stock market (just as my newsletter was doing before the recent cautionary shift).

If the current rally is for real, new buy setups will emerge to carry the market higher, and there will be plenty of time to participate in the profits.

But regardless of which way the market heads from here, the bottom line is I still have no subjective bias, and continue to operate under the mantra of “Trade what I see, not what I think.”

If you do the same, your trading account will thank you every time.