Watch for a Market Swoon in Late October

by Serge Berger | September 27, 2013 12:57 pm

Equities have had another great run year-to-date, with the S&P 500 currently up by just around 19%. What’s ironic about the rally is that most everyone is aware of it, yet a good number of investors still won’t acknowledge it, much less participate in it.

As always, there are plenty of both fundamental and macro arguments against the rise of equities again this year. But to me, at the very core of it all, those not participating in the rally are simply making classic mental errors and not letting the market tell them what to do. “Stubborn” and even “snooty” are words that come to mind when I think back to some conversations I had with self-proclaimed bears that fought every uptick in the market.

From disagreements with current monetary policy to “weak” global growth and concerns over geopolitical flare-ups, the bears have pointed to everything in sight. Yet the simplest thing of all — higher highs in stocks — gets ignored or ridiculed.

Free up your mind, folks.

Let the market signal you the path of least resistance. At the end of the day, while it’s not easy, it’s also not nearly as complicated as many make it out to be.

On Sept. 18, Ben Bernanke threw investors his latest curveball, which initially spiked stocks higher. But a few days later, the majority of U.S. equity indices had retraced almost all of the post-FOMC rally. While there is an underlying bearish tone to all of this, the fact that many sectors in the S&P 500 are trading in more of a consolidation pattern than a correction pattern makes me think stocks are not yet ready to slump more than a couple percent lower.

On the daily chart of the S&P 500 below, note that the index remains trading above and respecting its November 2012 uptrend as well as its 100-day simple moving average (blue uptrending line). A break of those support lines would be one of the clearest bearish signs.

spx daily
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When looking for “corrections” of at least 5%, I like to see negative divergence between momentum oscillators like the Stochastics, Relative Strength Index (RSI), MACD and price action. In other words, in the current environment, I would like to see oscillators begin to form lower highs as upside momentum wanes, while price continues to climb.

We are already seeing some of this negative price divergence between price (higher highs) and the MACD momentum indicator (lower highs) on the lower part of the chart. However, as this isn’t the case with the other aforementioned momentum indicators, I’m not getting too bearish in the intermediate-term.

Beyond the immediate-term of the next few days, I see good reason to believe that we are in for a better correction around 5% at some point toward the second half of October, possibly into early November. Such a mean-reversion move could find support at a retest of the late August lows near 1630 on the S&P 500. There is plenty of seasonal weakness to also support at least a dip in stocks in the late-September/early October period.

Furthermore, as many funds will have to play catchup into year’s end, it is conceivable that the sell-side institutions will let stocks slip some before again stepping in, then letting buy-side and retail investors purchase stocks at higher prices as Jan. 1 nears.

Small-cap stocks — as represented by the Russell 2000 on the below chart — have exhibited respectable relative strength vs. large-cap stocks of late, which ultimately should prove to be a powerful rally endorser into year-end.

Click to Enlarge

However, if the broader market wants to fake out investors before rallying higher into year’s end — which remains my base case — then a moderate retracement of a few percent, possibly toward the 1,040 area on the Russell 2000, is conceivable before the second half of November arrives.

Serge Berger is the head trader and investment strategist for The Steady Trader[1]. Sign up for his free Weekly Market Outlook Video here[2]. As of this writing, he did not hold a position in any of the aforementioned securities.

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