Stocks: Possibility Of A Correction Approaching - Part I

In yesterdays Quote Of The Day post, a bullish comment about Chinese stock markets was made. I tend to agree with that comment and I was actually going to write about it in today's stock post update. However, I feel there is a more pressing issue at hand and that is the possibility of a correction in coming days or weeks. As a matter of fact, a good friend of mine wrote to me specifically about the topic in various emails this morning. So let me put forward some evidence I am looking at...

Economists Are Bullish

According to the Citigroup, economic surprises in the US, as well as in the overall Developed Market space, continue to come out on the upside. That usually means economists are now too optimistic on the current set of data and will be rising their expectations in the future. As we can see from the chart above, that usually but not always, creates under performances with the S&P 500. Many investors seem to think that there is a lot of similarities with mid 2008, but I am not one of those.

Having said that, this type of a signal tends present excessive bullishness towards pro-cyclical type of stocks that link to strong economic performance and therefore could be used a contrarian indicator to shift towards more defensive sectors.

Technicians Are Bullish

After reading several newsletters from investment banks on technical analysis, I noticed that the consensus seems to be leading towards a potential bullish outcome every since the 200 day moving average and the triangle inflection point was broken on the upside. The problem is that majority are looking at the same pattern outcome and executing it on the long side. When you are following the herd, also known as dumb money, you do not stand with high probability that you will be right on your trades.

Retail Option Traders Are Bullish

That perfectly links us to our next topic. The chart above, thanks to SentimenTrader website, shows that the overall Put Call Ratio is heavily leaning towards persistently large number of Call buying. It seems that majority of the retail investors now understand that the "triangle" as well as the "200 MA" is broken and therefore majority of these investors are place bullish bets on the market. On top of that, retail investors who use Equity Only options, are also displaying optimism for stocks.

Contrary to that, I have also noticed large Put buying with smart money traders, who usually use the S&P 100 OEX options. The readings over the last few days have been up to 3 times more puts than calls, which is usually quite an alarming signal (not shown in the chart here). On top of that, the Volatility Index (VIX) has now fallen to levels not seen since late July, prior to the S&P downgrade of the US. I wouldn't go as far as to say market investors are complacent, but I would say that current VIX levels have also reduced the price of Put options to more affordable risk reward ratios. In other words, we can at least say that smart money is using cheaper options to hedge their gains.

Retail Investors Are Bullish

As I already covered in the Chart Of the Day post last week, AAII sentiment has now reached a level usually associated with short term pull backs or corrections. Bearish sentiment particularly is quite worrying as only 17% of all participants surveyed were bearish. That is the second lowest reading over 5 years and warrants some caution. On the other hand Investor Intelligence Survey does not show excessive optimism as of now.

Breadth Is Overbought

Some of the breadth signals I follow are slightly overbought at present. The 10 Day Advance Decline Line is currently at overbought levels, which at times leads to a mild correction as we can see from the chart above. On top of that, percentage of stocks above the 50 day moving average is now entering 80% plus level, which tends to be overbought too.

Finally the up-tick, down-tick close breadth measure (TICK) is now approaching overbought levels over the last 10 day average readings. Usually equity markets tend to struggle with gains when TICK gets this overbought as we can see from the chart above.

Blue Chips Are Overbought

Finally, blue chip stocks like McDonalds and Apple, which have been bull market leaders since March 2009 lows, are now extremely overbought and at 52 week new highs. Of course, that does not mean prices could not go even higher, but I'd be very cautious about investing in these types of equities right now. They seem quite stretched from their 200 day moving average, so I'd rather wait for a pullback instead.

Summary

There is a significant evidence that equity markets are potentially setting themselves up for a correction of some type. Certain investor groups within the market are showing optimism, be it economists or options traders. Furthermore, it should be windily known that as of mid to late January, equity markets tend to experience a bad seasonal effect. Therefore, there is a tendency to sell stocks into a January reporting season.

So what does all this mean... a continuation of the bear market?

I highly doubt it. Quite to the contrary, I'd argue that this will be a slight bump in the road as the market grinds higher towards a new 52 week high later in 2012. I would be looking for the S&P 500 to at least test, if not better its May 2011 resistance in months or quarters from here. With investors extremely optimistic on the Treasury Bonds and the US Dollar, I'd rather think that the major surprise after this correction, will be decline of those Safe Haven assets (but more on that in coming days / week).