Signs Point to an Overextended Bull Market That Could Sell-Off

The stock market consolidated its gains last week while waiting for news. Earnings announcements this week could push prices out of their two-week trading range.

Traders Will Get the News They Want This Week

Stocks spent last week consolidating the large gains from the first trading day of the year. SPDR S&P 500 (NYSE: SPY) gained 0.48% and PowerShares QQQ (NASDAQ: QQQ), an ETF that tracks the 100 largest Nasdaq stocks, added 0.95%. The iShares Russell 2000 Index (NYSE: IWM), an ETF that tracks small-cap stocks, was the biggest gainer among major stock market indexes two weeks ago, but added only 0.11% last week.

Odds favor a pullback, as I wrote last week. In the futures markets, smart money continues to sell while small speculators are excessively bullish.

A popular sentiment index, the AAII Investor Sentiment Survey, also shows that individual investors are growing increasingly optimistic. The percentage of bulls jumped 7.7% last week and is now at 46.4%, significantly above the long-term average of 39% bulls.

Individual investors are also putting real money behind their opinions and equity mutual funds reported their largest inflow since May 2001. These numbers indicate that optimism is becoming excessive in the stock markets, a condition more often seen at tops than bottoms.

In addition to sentiment, earnings estimates continue to drop. S&P began their weekly analysis by noting, "Currently 18 of 28 issues that reported earnings beat their expectations. However, the narratives have been negative."

This indicates company management expects to see the slow growth in the economy continue and the economic news is still bad. Global economic weakness shows no signs of turning around. In fact, real GDP in the euro zone probably contracted for the fifth consecutive quarter in the fourth quarter of 2012. The euro zone is a large trading partner of the United States with annual trade topping $1 trillion. It seems unlikely the U.S. recovery can accelerate until Europe is growing.

Despite all the negatives, major stock market averages are up 5%-7% in the first eight trading days of 2013. A pullback seems likely and chasing stocks at this point is a high-risk strategy. This bull market is nearly four years old and is overextended. Stocks are at the upper end of a 15-year trading range.

SPY Chart

Long-term and short-term charts are overbought and this current bull market has delivered bigger gains than the previous bull, a sign that it could be near an end. With earnings season picking up this week, the best trading strategy is probably to sit on the sidelines and wait to see how markets react to the upcoming news.

ProShares UltraShort QQQ (NYSE: QID), a leveraged, inverse ETF that tracks the Nasdaq 100, hit the stop-loss at $28 last week and was closed with a loss of 9.79%. That was certainly disappointing, but given the risk in the stock market, that ETF might be the best buy again within the next few weeks.

Gold Selling Accelerates as Price Moves Sideways

SPDR Gold Trust (NYSE: GLD) gained 0.39% in active trading last week. Volume was well above average on Thursday and Friday, but GLD ran into resistance at the 20-day moving average.

Gold remains under pressure as hedge funds have been large sellers since the end of November. According to the Commitment of Traders (COT) report, large speculators have decreased their holding by 26% in the past six weeks.

Despite the heavy selling, an indicator based on that data shows that the selling could continue. The indicator converts the raw COT data to an index similar to stochastics and stands at 30. It usually falls below 10 before gold prices bottom.

Gold Chart

PowerShares DB Gold Short ETN (NYSE: DGZ), an inverse fund that gains when gold prices fall, fell 0.41% last week but is still a buy.

Recommended Trade Setup:

-- Buy DGZ up to $12.25
-- Maintain stop-loss at $11.25
-- Maintain price target at $14

This Week's News

There will be a few economics reports this week. Retail sales will be reported on Tuesday and is expected to paint a picture of a slow-growing economy. Housing starts on Thursday should show improvement in real estate but should also be consistent with slow growth in the fourth quarter of 2012. The big news will be earnings as a number of companies make announcements.

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