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Are Stocks Entering a Downtrend?

Investors should look for opportunities on the short side


Markets are down around the world Friday on renewed fears over monetary tightening measures in China and concerns over the health of the indented nations on the periphery of the euro zone. This continues a four-day long slide for U.S. equities.

One of the main drivers of the post-August rally — technology stocks — have hit a wall this week after tech bellwether Cisco (NASDAQ: CSCO) reported weak forward guidance. This has taken the wind out of the sails of the risk trade — setting the markets up for a significant new downtrend.

In Thursday trading, the Technology SPDR (NYSE: XLK) lost 1.5% while the Semiconductor HOLDRs (NYSE: SMH) lost 1.1%. That was enough for the XLK fund to made a classic “island reversal” pattern that fully reversed the post-QE2 gains and points to more weakness in the days and weeks to come. Indeed, the XLK is down another 0.8% in Friday trading while the SMH is well off of its highs.

Both of these important sector groups now appear to be losing their post-August uptrend with technology stocks moving below their 20-day moving average on an intraday basis for the first time since early August — an event which marked the beginning of the pullback from the July high.

Breadth is also narrowing, with the percentage of NYSE stocks above their 50-day moving average moving down to the pre-QE2 low of 80% — a sign the bulls are seeing fewer and fewer bargains out there. Like a house on shaky foundations, this is a sign prices need to come down.

Another sign of weakness comes courtesy of the McClellan Oscillator, which is a breadth momentum gauge. You can see how the oscillator has moved back under zero after an excursion above in the wake of the Fed’s QE2 decision. A quick up-and-down, without forming a complex pattern above zero, suggests that the bulls are losing their grip on the stock market.

And finally, there the bond market is showing signs of stress as the High Yield Bond SPDR (NYSE: JNK) fell for the fifth-straight day today as it crossed below its 20-day moving average. This hasn’t happened since early April. Also, selling has picked up intensity with the on balance volume indicator moving below its 20-day moving average. Over the past year, weakness in the “junk” or high-yield bonds are behind JNK has presaged weakness for stocks.

One of my contacts at a large investment consultancy that sits between large pension plans and some of the best-known bond fund managers indicated that people are worried that interest rates are too low at these levels — especially with inflation expectations on the rise (one of my favorite topics lately).

Given all this, I recommend investors look for opportunities on the short side. Emerging market and European equities look particularly vulnerable right now. In my next post, I’ll have a few specific ideas.

Disclosure: The author does not own or control a position in any company mentioned.

Be sure to check out Anthony Mirhaydari’s new investment advisory service, the Edge. A free trial has been extended to readers. Log in with “freeuser” as the user name and “edge” as the password.


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