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Market Outlook: Add Some Protection Against an Impending Sell-off

There are some indicators pointing to a possible top, but the weight of the evidence is not saying it's time to sell. Traders should, however, start getting more cautious and move their stops closer to current prices.

Weight of the Evidence is Bullish

There are always a number of factors to consider when making decisions about buying and selling in the market. Many traders have a tendency to either ignore much of the data and focus on only one or two pieces of information, or become overwhelmed to the point of indecisiveness by all of the available data. These are two extremes, and there are a number of points that lie between them.

To address this problem, some market analysts base their decisions on the idea of the "weight of the evidence." I first came across this idea in Martin Pring's 1991 book, Technical Analysis Explained, where he wrote the goal of technical analysis "is to identify trend changes at an early stage and maintain an investment posture until the weight of the evidence indicates that the trend has reversed."

This offers an excellent definition of what we, as traders, do. "Weight of the evidence" is a legal term that means evaluating "the strength, value and believability of evidence presented on a factual issue by one side as compared to evidence introduced by the other side."

Just like in court, there will almost always be two sides to the story -- a bullish and bearish argument -- in any market. The stronger argument, not the one that agrees with your bias, should dictate how to trade.

SPDR S&P 500 (NYSE: SPY) gained 1.78% last week and is within 1% of its all-time high. This is the bullish side of the argument, because rising prices are simply bullish by definition. There is no evidence that the trend has reversed based on price action.

Evidence supporting the bearish side of the argument is found in divergences and seasonal tendencies, among other indicators.

Two divergences are shown in the chart below. In the most recent upswing, SPY has not reached the upper channel line that has defined its uptrend since November. The upper channel is drawn 4% above the lower channel and has contained the price gains since November.

SPY Chart

The second divergence is in the stochastics indicator, which did not confirm the April high in price. Stochastics is significantly below its March peak, even as prices have remained near their previous peaks.

Seasonally, we are near the time to "sell in May and go away." According to research done by S&P Capital IQ, since 1945, the S&P has underperformed in the six months between May and October when compared to the November to April time frame. This is a weak argument, though, because the S&P 500 index has actually been up about 63% of the time during those six months, although the average gain is only 1.2%.

Neither the divergences nor the seasonal tendency are enough to change the weight of the evidence to the bear's favor. Stocks remain near all-time highs. As Pring explained, we should maintain a bullish investment position until the weight of the evidence shows the trend has reversed.

For now, it looks like we could see a pullback. To protect against the losses that could result if the pullback turns into a bear market, it is a good idea to raise your stop-loss levels.

The chart above shows that SPY faced resistance at $152. That level should serve as support now, and a break below $152 could signal a trend reversal.

Recommended Trade Setup:

-- Maintain long position in SPY
-- Maintain stop-loss at $152
-- Maintain year-end price target of $167, which should be reached after a pullback

Gold Up Despite Lack of Buyers

SPDR Gold Trust (NYSE: GLD) was up 4.02% last week after a 15% drop in the first weeks of April. The public seemed to be buying as much gold as they could after the price pullback. The U.S. Mint sold out of its supply of one-tenth ounce gold coins, a sign that small investors were bargain-hunting.

Demand for gold did not extend much beyond coins. A few weeks ago, I showed that the amount of gold held by GLD has been tracking the price of gold closely for the past couple years. This week, the amount of gold held in GLD fell 3% even as the price of gold moved up. This could be a sign that individual investors are taking any profits they have or giving up on the prospects of gold. Either way, if the assets in GLD fall, the price of gold has limited upside until buyers return to the market.

Futures traders also reduced their exposure to the metal. Large speculators reduced the number of contracts they are holding by 19% last week.

Gold Chart

With individuals and institutions selling, gold could resume its decline. In gold, the weight of the evidence points to a downtrend in place, and a week's worth of gains did not change that.

PowerShares DB Gold Short ETN (NYSE: DGZ), an inverse fund that goes up when gold prices fall, was down 3.1% last week, but is still up 9.71% since the beginning of April. Until the trend in gold changes, DGZ provides the lowest risk and strongest potential gains in the metals market.

Recommended Trade Setup:

-- Buy DGZ on pullbacks below $13.20
-- Maintain stop-loss at $12.65.
-- Maintain price target at $14.60

This Week's News

As April ends and May begins, there will be some key economic reports and a Fed policy meeting that could be market moving this week.

Michael J Carr Market Outlook