Market Outlook: Little-Known Indicator Warning of a Pullback

Last week's gains in the stock market highlight the increasing bullishness of traders. But one little-known indicator shows this market looks surprisingly like 2007. However, because longer-term indicators show economic strength, any sell-off in stocks should be brief.

Bulls Might Be Pushing SPY Up Too Fast

SPDR S&P 500 (NYSE: SPY) broke through short-term resistance after the Labor Day holiday and gained 1.46% for the week. While this seems bullish, there is a troubling analogy to 2007 building in the market that warns of potential problems.

One indicator I watch closely is the distribution of returns. In the long run, markets tend to be up about half the time and down about half the time. When market gains are recorded much more than 50% of the time, we often see a market reversal.

I also look at the average size of the daily market gain. Small changes are normal. For example, since 2001, SPY has closed up on 54% of all trading days with an average daily gain of 0.02%.

Since the beginning of the year, there have been an unusually large number of up days in SPY and the average daily gain is more than four times larger than the long-term average.

Through the end of August, SPY has gained an average of 0.09% per day and has been up on 58% of trading days since the beginning of January. This is the best performance in the first eight months of the year since 2007 when SPY was also up 58% of the time. The average daily gain in 2007 was only 0.03%.

Over the long run, stock prices show a tendency toward mean reversion. This means that periods of above-average performance are often followed by periods of below-average performance. With stocks delivering above-average gains in the first eight months of the year, it is logical to expect below-average gains in the rest of the year.

However, trends can continue longer than expected, and mean reversion can also be achieved if prices remain in a trading range for an extended period of time.

For now, I believe that a trading range or a short pullback in the stock market will resolve this overbought condition.

Whether stocks move higher or lower from here could depend on the economy. As usual, many analysts had comments on the unemployment report. Unemployment fell to 7.3%, which puts it closer to the Federal Reserve's target of 6.5%.

Some analysts argued that the report contained more bad news than good. Only 169,000 jobs were created instead of the 180,000 economists expected. The workforce participation rate fell to 63.2%, its lowest level since 1978.

These might be valid concerns, but through testing I have learned that the monthly employment report has almost no relationship to the future trend in stock prices.

Unemployment is a coincident indicator of the stock market. Coincident indicators move along with the general price trend. Leading indicators help to predict the future direction of the trend. New unemployment claims, for example, are a leading indicator of the stock market.

New claims can be volatile from week to week, and a four-week moving average is often used to smooth the data. The four-week moving average of new claims has fallen to its lowest level since October 2007. A decline in new claims is usually bullish for stocks.

Another leading economic indicator, the new order component of the ISM Manufacturing Survey, is also bullish. This indicator ranges from 0 to 100, but most readings are between 40 and 70. Values below 50 for several consecutive months are usually seen before an economic contraction and a stock market dip. The most recent value of the new order index is 63.2, well above 50 and bullish for stocks.

The relationship of this indicator to the stock market is shown in the next chart. The 12-month rate of change (ROC) for new orders and the S&P 500 index have moved in the same general direction for many years.

New Orders

In addition to these two leading indicators, I follow a model that uses input from seven different economic indicators and that is also bullish.

Stocks can turn down at any time, but we generally see the economy turn down first. With leading economic indicators in bullish territory, there is no reason to expect a bear market. Any weakness in the stock market should be viewed by long-term investors as a buying opportunity for now. For the short-term, I am comfortable with a small position in inverse ETFs like ProShares Short S&P 500 (NYSE: SH) as a hedge against a short-term pullback.

When the economic indicators deteriorate, I will become bearish.

Gold Posts Small Loss as Talk of Military Action Picks Up

SPDR Gold Shares (NYSE: GLD) fell 0.35% last week, posting a small loss for the second week in a row. Gold has traditionally been viewed as a hedge against political crises. The failure of the metal to rally on news related to Syria seems to be bearish for gold.

The lack of a rally is especially surprising given that gold is now more oversold than it has been at any time since 1999. The next chart highlights that period of time, when gold was building a multi-year base before beginning the extended bull market that ended in 2011. Oversold is being defined as a negative or low value of Bollinger PercentB, an indicator that defines where prices are relative to the Bollinger Bands.

Gold Market Outlook Chart

Volatility, measured with the Bollinger Bandwidth indicator and shown in the center of the chart, is high. This indicator tends to move in cycles between high and low values. At this point, it is likely that volatility will fall. This would indicate that gold should be expected to remain within a relatively narrow trading range.

Gold seems to offer little upside in the short term and traders can find better opportunities in other markets.

This Week's News

It should be a quiet week in the markets as traders wait for the Fed meeting that begins on Sept. 17.

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