Wall Street's latest rally has many flaws

NEW YORK (Reuters) - With U.S. stocks pressing up against 17-month highs, the inevitable question arises: “Does this rally have legs?”

Traders work in the oil options pit of the New York Mercantile Exchange March 11, 2008. REUTERS/Chip East

From one perspective, things couldn’t look rosier for the bulls. The S&P 500 touched another 17-month high on Wednesday, breaking through levels analysts identified as significant resistance. More stocks in the S&P are hitting fresh 52-week highs than at any time during the course of the rally.

But the steady rise in the last six weeks has been accompanied by middling volume and underperformance in key areas, such as semiconductor companies. Market technicians and strategists believe the current run is overbought, suggesting at least a near-term pullback.

“What we are seeing represents a very defensive stance among investors,” said Mike O’Rourke, chief market strategist at BTIG, an institutional brokerage firm in New York. “You are seeing investor disinterest in equities and that’s why volume is languishing here.”

This week’s consolidated volume has been telling. With major averages hitting recovery highs, Monday marked the third slowest volume day of 2010 when about 7.24 billion shares traded on the combined New York, American and Nasdaq stock markets, below last year’s estimated daily average of 9.65 billion.

The tepid volume suggests a lack of broader conviction, and is a sign momentum is mostly behind the latest run-up rather than any broad-based accumulation of stocks.

Momentum investing relies on chasing short-term price action on hard-charging stocks and shunning those that appear to be out of favor.

John Kosar, market technician and president of Asbury Research in Chicago, said there was a growing risk the run-up that resumed in February was a “countertrend” rally within a larger decline that began in January.

“Volume measures investor urgency and this recent lack of urgency to buy is characteristic of either peaking markets or countertrend rallies,” he said.


Investors were abuzz this week as the benchmark S&P 500 took out resistance at the 1,150 level. Investors see that as clearing a path to a run to 1,200. But other important technical metrics are not garnering the attention of the overall average.

According to Reuters chart data, the S&P 500’s 14-day relative strength index (RSI), which measures the magnitude of the gains to determine overbought or oversold conditions, is hitting levels not seen since September 1995 -- approaching 91, a threshold that technically signifies an overbought market.

An RSI ranges from zero to 100. When it approaches 70 that traditionally signals an overbought condition in an asset or an index, and the risk of a pullback increases.

Additionally, Bespoke Investment Group, an investment research firm in Harrison, N.Y., pointed out that 89 percent of S&P 500 stocks are trading above their 50-day moving averages, a level that usually augers for a pullback in the short-term.


The semiconductor index .SOXX has failed to confirm coincident 19-month closing highs in the Nasdaq Composite index .IXIC, a bearish development considering technology's tendency to lead the market's advances and declines.

For a graphic on the semiconductor sector's performance in 2010, click here:

The S&P 500 .SPX is up 10.3 percent since its recent closing low of February 8, while the small-cap benchmark Russell 2000 .RUT has rallied more than 16 percent over the same period. Year-to-date the S&P 500 is up about 5 percent, whereas the Russell 2000 is up 9 percent.

To be sure, the run-up in small-cap stocks shows how risk appetite has risen due to optimism about the U.S. recovery. Small-cap companies are viewed as more nimble and among the first to benefit from an apparent recovery.

But the divergence between strength in the Russell 2000 and the semiconductor index should be taken as a cautionary tale. Divergences occur when key indexes move in the opposite direction of the market’s primary trend and tend to catch investors off guard.

Analysts say another ominous development is the sharp decline in overall volatility, suggesting complacency is setting in. The CBOE Volatility index .VIX, Wall Street's favorite gauge of investor sentiment, is trading at 22-month lows below the 17 level.

According to Kosar, declines to 18 or lower in the VIX have either coincided with or led every important near-term peak in the S&P 500 since October 2007. He said the market’s gains may be limited without a near-term decline to work off extremes in investor complacency. VIX futures suggest a rise in volatility later this year.

“Although the February rally in U.S. equity prices may continue from here on a week-to-week basis, a sustainable advance is unlikely from here without at least one to several months of a corrective decline first,” said Kosar.

Reporting by Ellis Mnyandu; Editing by Andrew Hay