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4 Technical Indicators to Watch for a Market Pullback
With markets near highs, watch these metrics for signs of a shift.
With the Standard & Poor’s 500 index up double digits since the beginning of the year and up more than 100 percent since March of 2009, a question in nearly every investor’s mind is, “When will the good times end?” While there have been some hiccups along the way, the general trend for the stock market has been up, up, up. This has been great for investors’ portfolios, but there will come a time when this trend will reverse as the business cycle peaks and subsequently contracts. Nobody really knows exactly when this will occur, but here are four indicators that I think investors should consider monitoring when trying to determine if the market is preparing to change course. Good resources for up-to-date readings of the first two indicators can be found on Dorsey Wright & Associates’ website, and Stockcharts.com includes the status of the third and fourth.
1. Positive Trend Percentage.
This indicator measures the percentage of stocks in an index that are trading in a positive trend. When it falls below 50 percent, the market tends to decline, and when it’s above 50 percent, it’s considered a healthy sign. To use recent history as an example, the positive trend percentage for the S&P 500 fell below 50 percent in January of 2008 and didn’t rise above the 50 percent mark until May of 2009, which was three months after the market high and two months after the low. During that time, the S&P 500 lost 30 percent. As of mid-September, the positive trend percentage for the S&P 500 was around 90 percent.
2. Offensive Assets versus Defensive Assets.
From a relative strength perspective, when defensive asset classes start outperforming offensive asset classes the stock market may be ripe for a pullback. Defensive asset classes include money market funds, bonds and foreign currencies, and offensive asset classes are defined as U.S. stocks, non-U.S. stocks and commodities. Dividing the price of the S&P 500, which tracks large-cap stocks, by the price of the Russell 2000 index, which tracks small-cap stocks, would give you the relative strength of large-caps stocks versus small cap stocks. As this number gets larger, large caps would be outperforming small caps and, inversely, small caps would be outperforming large caps if the number gets smaller. If you calculate the relative strength numbers for those six assets classes against each other, current readings of this indicator are mixed. U.S. stocks and non-U.S. stocks are outperforming all other asset classes but commodities are underperforming.
3. Trend Lines.
One of the fundamental pillars of technical analysis is that prices exhibit trends, and those trend lines are either viewed as a floor (or support) when prices are rising or a ceiling (or resistance) when prices fall. I won’t go into detail as to how trend lines are constructed, but if an index breaks through a ceiling or a floor, it typically means that supply has overtaken demand or vice versa and a change in trend could be imminent. The S&P 500 started a positive trend in October of 2011, briefly broke through its floor during the fiscal cliff concerns towards the end of 2012 and started a new positive trend in November of 2012. Based on where the S&P 500 is trading, the positive trend line won’t be violated until it falls approximately 10 percent to the 1,550 range. At that point, this indicator would suggest that the market is weakening.
4. Bullish Percentage.
Another sign to watch for, to indicate a potentially deteriorating market, is if the Bullish Percentage chart is showing lower and lower tops. The Bullish Percentage indicator measures the percentage of stocks in an index that are on a buy signal using traditional point and figure analysis. When readings are above 70 percent, the index is considered overbought and when it’s below 30 percent, the index is considered oversold. However, unlike the positive trend percentage, the direction of this indicator is more important than the level. If the Bullish Percentage chart forms lower and lower highs, this is a sign that fewer buyers are participating in the market to keep it supported. The latest peak for this indicator for the S&P 500 occurred in May of 2013 at nearly 90 percent. Two months later it formed a top around 80 percent. If we see the next top only reach around 70 percent, this may be a bearish sign of things to come.
Technical analysis doesn’t give anyone a crystal ball into the future. It does give investors additional tools with which to measure the battle between buyers and sellers. I hope these four indicators help you as you monitor the markets.
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