Over the past week we saw improvement in almost all of the market health indicators that we track allowing us to move to a 100% long position in our hedging strategies. Our measures of market quality improved slightly, market strength improved substantially, and our trend indicators finally confirmed. Our measures of the economy turned positive, but are still on the weak side causing concern that the positive signal may not last long. Our measures of risk remained positive, but flat, even as the market moved higher.
Our Twitter sentiment indicator for the S&P 500 Index turned positive on a short term basis. In fact, it had the highest reading to date on a daily basis. This reading signified confirmation of the close on SPX above 1422. Our smoothed sentiment indicator has strengthened over the past three weeks, but is still painting a series of lower highs for the entire rally out of the June lows. This comes as a result of many market participants tweeting over the last three months that this rally can’t last due to market valuations, economic concerns, and tail risk events such as the Euro crisis.
Recently we’ve seen a high volume of tweets talking about the current move above 1422 in the S&P 500 Index being a false break to the upside. Many traders are positioned net short and not afraid to be so. They cite technical factors such as the Dow Jones Transportation Average breaking down and fundamental concerns on the economy as reasons to avoid the market.
A resistance level or price target of 1440 on SPX has been mentioned so overwhelmingly in the past week that any move above that level could bring with it a flood of short covering. We think it possible that a short covering rally could take SPX quickly to the next line of major resistance at 1500.
UPDATE 9/10/2012 – NYSE Short Interest ratio at at a 5 year high is confirmation of what we’re seeing on Twitter about the number of shorts out there.
On a continuation of the rally we’ll be watching for a shift in our smoothed sentiment indicator that breaks the recent highs and more importantly gives a reading above zero. We believe that a positive shift in sentiment could create a substantial rally as it will represent the recent wall of worry breaking. This will cause demand for stocks as traders and investors buy in fear of missing the next move up. There are a few calls way above the market at SPX 1600. We feel that only a rotation out of safety and into risk could fuel a rally to that level.
Below the market we have a few isolated calls for 1280 and 1375, however, the vast majority of tweets put in a floor of 1390 to 1400. So the important support and resistance levels to watch are 1390 on the downside and 1440 above.
Several positive developments in technical indicators occurred this week. Both NYSE and Nasdaq new highs improved substantially confirming the move above resistance. The Bullish Percent Index moved up strongly as well, signalling that weak chart patterns gathered strength. Many of the major indexes are breaking out together confirming broad participation in the rally.
While the Dow Jones Industrial Average closed above the last secondary high, the Transportation Average did not confirm. More concerning is that the transports are just a few points above the bottom of the Dow Theory line that it broke down from in May. This is sending a signal that even though prices are moving higher in the broad indexes the economy might not be healthy enough to support higher prices.
Our Market Risk Indicator flashed a warning early this week as the S&P 500 Index was on the verge of a break below recent support in the 1390 to 1400 range. The strength in price that followed reversed the warning leaving it positive for the week (we require a weekly signal to add aggressive hedging to our portfolio). Although our risk measures remained positive they stayed flat and somewhat weak. This puts us in a position where overall market health is positive, but risk could enter the market at any time. We’re comforted by the fact that the risk indicator appears to recognize the tail risk of Iran, the Euro crisis, and the US fiscal cliff. If any of these events turn ugly or we break important support levels we should move quickly to an aggressively hedged position.
We’re cautiously optimistic due to the underlying health of the market and positive price action, but fully aware that economic strains or event risk could bring the end of the current rally.