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In my previous commentary, I suggested there was a high probability that stock prices could experience a pullback as investor sentiment had reached overly bullish levels. 

Since the current rally started 5 months ago, traders have clearly favoured a risk-on strategy, targeting those sectors of the market that were closely linked to economic growth and corporate profitability. As a result, the majority of traders were firmly in the bullish camp and the short term trend was clearly 100% risk-on. 

For 5 months the unloved defensive sectors lagged the main stock market indices. However, this changed last week as leadership was evenly split between the risk-on and defensive sectors of the market. It is my view that traders are now at an important inflection point. The short-term trend is no longer clear, as half those bullish traders have now turned bearish on stocks. The remaining bulls will fight hard to push stocks higher, while the bears will look to capitalise on a correction by shorting stocks. This match-up is commonly known as the “tug-of-war between bulls & bears” and normally occurs at market tops and market bottoms, when the short term trend is potentially changing and no longer clear. 

Trading volume on the NYSE during the month of January hit a 13 year low. This is a major concern for the bulls as strong up-trends in stocks are always associated with high trading volumes. 

In the short term, I am still bearish on stocks and believe a correction is required to reset the overbought and over-bullish investor sentiment readings. In this week’s commentary, I will examine last week’s performance of the risk-on and defensive sectors and discuss what we may expect from stocks going forward.

Commodities were the best performing asset last week. The decline in the US dollar was the main driver behind the rally as commodities have an inverse relationship to the dollar. However, to demonstrate how dysfunctional the market has become, the Canadian and Australian dollar, which are both commodity currencies, declined last week. Turning to stocks, while the industrial, technology and the material sectors all showed strength relative to the S&P500, weakness amongst key growth sectors such as financials, transportation and small capitalisation stocks undermines the risk-on rally. The 20-year US government bond, which is considered the ultimate safe-haven asset, doubled the return of the S&P500 index last week. This was the first time in 5 months that defensive bonds outperformed stocks and should be treated as a major warning sign.

The table above from SentimenTrader.com is a consolidation of the various investor sentiment indicators for each of the risk-on and defensive sectors. Only 3 defensive sectors remain in a neutral zone (I have circled these in blue). The risk-on sectors are all extremely overbought.

In last week’s commentary I expressed concerned that the Dow Jones Transportation index was lagging behind the Dow Jones Industrial index. Unfortunately, the transportation index declined further last week, falling below its 50-day moving average trend line, which is a key support level. The transportation index has now declined by 4.5% since peaking in January.

The window at the top of the chart shows the relative strength line of the transportation index relative to the industrials index. Since the current rally in stocks started on 3rd October 2011, the transportation index led the industrials index, resulting in a rising relative strength line. However, the ongoing relative weakness since the start of February (falling line) is a major concern. 

In my opinion, stocks are in the process of forming a short-term top. Apart from the warning signs I discussed in last week’s commentary, I believe the most significant signal is the recent weakness stocks are showing in the face of strong economic data released last week, namely:

When stocks are unable to move higher in response to strong economic data, this usually suggests the rally is exhausted and the data has already been factored into the price of stocks. 

Thanks for reading.