Cracked Wood in Market Resistance Zone Spells Trouble

by Richard Band | August 22, 2012 9:24 am

August was shaping up as a great month for stocks—and it still is.  But Tuesday’s sharp intraday reversal (the Dow fell 144 points from its morning high to the afternoon low) provides a strong hint that the easy gains are behind us.  The market has entered a major resistance zone, where the first crack in the wood can soon lead to much wider fissures.

Meanwhile, a question keeps nagging at more and more investors:  “Why, with the market indexes pressing up against new multi-year highs, are so many of my stocks acting listless or even declining?”

The short answer is that the headline indexes are freighted with big-name companies.  If just a handful of these stocks are roaring ahead (Apple (NASDAQ:AAPL[1]) is the gorilla right now), they can give the impression that the market as a whole is performing better than it really is.

In fact, narrowing participation, with investors “circling the wagons” around a few supposedly safe names, has characterized most of the big market tops through the years.

In the September newsletter, I pointed out to you three technical gauges that describe a narrowing, laboring market.  Here’s another that gives me pause.

This chart[2] plots the Value Line Geometric Index, a lesser-known stock index that assigns equal weight to approximately 1,700 U.S. companies.  Because of the equal weighting, the Value Line mimics the behavior of the great mass of stocks, rather than just a few blue chips.

The graph’s message is troubling.  The Value Line index is still languishing well below its April 2012 peak, even though the Dow and the S&P 500 have climbed almost all the way back to their April highs.  As a matter of fact, the Value Line made its high for the current market cycle in April 2011—16 months ago, an eternity by Wall Street reckoning.

Seldom does the Value Line diverge from the marquee indexes for such a lengthy period.  Indeed, since 1961, when the Value Line index was introduced, there have been only three instances where it lagged the Dow or the S&P for more than six months: in 1972-73, 1989-90 and 1998-2000.

In each case, the ultimate result was a steep market drop:  48% in 1973-74, 20% in 1990 and 49% in 2000-02.  (All figures basis the S&P 500.)

I can’t prove that a washout of 20%, 30% or more is in the offing.  I certainly hope not.  But I don’t like glaring divergences like this one.  That’s why I urge you, for the moment, to put your primary focus on selling stocks that may be vulnerable.  If my instincts are even half right, you’ll get a chance later on to buy many more (and better) bargains than you’ll find today.

Among our Standby holdings in the Incredible Dividend Machine, we’re selling Pfizer (NYSE:PFE[3]).  Drug stocks have been on fire lately, thanks to their rich dividends—and PFE has soared 39% since last October.

However, PFE’s earnings haven’t kept pace.  Profits are expected to fall about 4% in 2012, and merely regain 2011’s level next year.  Patent expirations will make it difficult for Pfizer to generate more than negligible earnings growth through the middle of the decade.  Take your money and run!

The same advice, by the way, goes for two other pharma stocks that haven’t been on our recommended list in quite some time, Bristol Myers-Squibb (NYSE:BMY[4]) and Eli Lilly (NYSE:LLY[5]).   Both companies are grappling with poor business fundamentals, while the share price has been inflated by investors craving dividends.  Sell.

Finally, we’re selling two ETFs we’ve been carrying as Niche Investments, iShares Dow Jones Healthcare Sector Index (NYSE:IYH[6]) and iShares Dow Jones U.S. Pharmaceuticals (NYSE:IHE[7]).  IYH has returned 29% in the past year; IHE, 36%.

That’s wonderful, but excessive, given the heavy pharma weighting in both funds (close to 100% in IHE).  Wave them good-bye.

  1. AAPL:
  2. chart:
  3. PFE:
  4. BMY:
  5. LLY:
  6. IYH:
  7. IHE:

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