The S&P 500’s Technical Problem is Actually a Valuation Problem

Yes, the market may have just completed its fourth straight week of forward progress, but just barely. The SPDR S&P 500 ETF Trust (SPY) only gained 0.44% last week, which was the most tepid weekly advance in the past four. And each weekly gain has been noticeably weaker than the previous one; the momentum is clearly slowing.

The question is, does this slowdown indicate the onset of a rollover for SPY stock, all the other market indices, and their corresponding ETFs? Or, is this just a rest period before the next bullish leg of the rally?

Technically speaking, stocks as a whole aren’t in pullback mode yet. From a realist’s perspective though, the S&P 500 has probably rallied about as much as it can, and from here is apt to be weak for a bit.

S&P 500, SPY ETF Drop a Suspicious Hint

The weekly chart of the SPY ETF may look bullish — momentum-wise — with just a quick glance. The longer one studies it though, the more red flags begin to wave. The biggest of those red flags is the decided deterioration of  volume on the way up.

The participation in the rally effort off of October’s lows was never as strong as the selling effort’s from early October was, but as long as there were more buyers than sellers, it was enough. We’re rapidly running out of buyers, however. In fact, as of last week we may simply have too few buyers to sustain the effort.

111614-sp500-spy-weekly

It’s conceivable that a new batch of buyers could crawl out of the woodwork if and when the S&P 500 index or the other major stock indices break above last week’s highs and rekindle the rally. Why did the rally slow in the first place though? The news delivered over the past four weeks has been bullish enough. Earnings for Q3 of 2014 are approximately 7% higher than Q3 2013’s levels, gasoline prices are at multiyear lows, and unemployment is also at a multiyear low of 5.8%. What’s there to be concerned about? Yet, investors clearly are concerned.

With all of that being said, it’s crucial to understand the S&P 500 is not yet technically in a downtrend. It’s merely caught in a narrow, sideways trading range between 2030 and 2046 now that the pace of the gain since Oct. 17 has slowed to a crawl. Once it breaks out of that range though — and it will — look for at least a small trend to develop in whatever direction that break is. (A downside break is the more likely income, for reasons that will be explained below.)

S&P 500

Just for the record, the waning volume behind the rally isn’t unique to the S&P 500 or SPY ETF. The Nasdaq Composite as well as the PowerShares QQQ Trust ETF (QQQ) have both seen volume dwindle the higher they’ve moved since late October. Ditto for the Dow Jones Industrial Average and the iShares Russell 2000 Index (ETF) (IWM). Indeed, it’s the Russell 2000 ETF that’s most troubling of all at this time.

Russell 2000, IWM ETF Wave a Red Flag

While a lack of volume is a concern, perhaps even more concerning is the red flag that the Russell 2000 Index (of small cap stocks) and its corresponding IWM ETF started to wave on Thursday, but underscored on Friday.

It’s often called a railroad track reversal by fans and users of candlestick analysis techniques. In simplest terms, it’s two taller-than average bars back to back — pointed in opposite directions — that materialize after the end of a prolonged move. The pattern suggests a trend has exhausted itself and is now reversing. It appears the Russell 2000 formed such a railroad track reversal pattern on Wednesday and Thursday of last week, and confirmed it with downside follow-through on Friday.

Russell 2000, IWM ETF

For the railroad track reversal to fully confirm its intention, the Russell 2000 will need to close below Friday’s low  1171.97 before breaking above Thursday’s high of 1188.67. If that happens, the profit-taking floodgates could open wide … at least in the near-term. On the flipside, even if the Russell 2000 manages to push above 1188.67 first, don’t plan on too much bullishness.

We’ve Got a Valuation Problem

It’s not a problem that shows up on any technical charts of the market’s key indices or ETFs. In fact, it’s a problem some pundits have outright denied. But, the bulk of the reason stocks are slowing down here is likely to be extreme valuations that leave little to no room for more upside.

As of  Thursday, with 94% of the S&P 500’s constituents having reported third quarter’s numbers, the S&P 500 is valued at a trailing price-to-earnings (P/E) of 17.8 and a forward-looking (12-month) P/E of 15.8. Both are beyond even the upper limit of what could be considered normal in a bull market. In fact, the market’s already demonstrated there’s a psychological cap on stocks at a trailing valuation multiple of just under 18.

The chart of the S&P 500 with its earnings history and trailing P/E illustrates this idea. Although the S&P 500’s trailing P/E ratio has hugged the 18 level for months, not once has it managed to move and stay above it for any meaningful length of time.

S&P 500 earnings, P/E ratio

This isn’t to say the S&P 500 can’t move in an upward direction from here. It is to say, however, with earnings growth expected to be limited to 12.6% for the next four quarters, there’s not a great deal of upside to look forward to. There’s still a strong likelihood of downside moves here and there, however, with one of those short-term (measured in days, perhaps a few weeks) dips starting to take shape right now.

Bottom Line

There’s a developing convergence of technical support for the S&P 500 at 1976. At that level, the index would have dropped 3.4% from its high, and would still be valued at a trailing P/E of 17.2. That might be enough to erase any worries regarding the possibility of an overbought or overvalued market. That’s a slim margin of error, however.

A more meaningful and more plausible correction would be a slide back to the 1900 area. That used to be something of a ceiling and a floor for the S&P 500. A move to that level would represent a 7.1% stumble from the high, and would also value the S&P 500 at a more palatable trailing P/E of 16.5. For the SPY ETF, the equivalent level is near $189.00.

The bearish ball could be rolling by the time this is published. It all starts when the S&P 500 moves under 2030.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2014/11/sp-500s-etf-technical-problem-actually-valuation-problem/.

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