Technical Analysis: The S&P 500 is Overbought

Equity markets have been on a tear thus far in 2012, with the S&P 500 soaring 7 percent and the tech-heavy Nasdaq up 12 percent. That’s the best start to a new year since 2000. In fact, the Nasdaq has rallied to an 11-year high.

We can argue the finer points of various economic indicators, but the stock market’s message is clear: The US economy won’t lapse into recession over the next six to 12 months and fear surrounding the EU credit crisis has abated, at least temporarily. The risk-on trade is likely to persist through first half of 2012. However, the uncertainty associated with the upcoming US presidential election increases the likelihood that the stock market will sell off in the back half of the year.

The S&P 500 could also take a quick breather in the next few weeks, as the recent rally has reached levels where investors will be tempted to take some gains off the table.

Although I usually analyzed economic fundamentals in this publication, technical analysis has its place in every investor’s toolkit. Some dismiss technical analysis as mumbo jumbo, but institutional traders factor technical levels and indicators into their decision-making–this mumbo jumbo can affect the market, especially in the short term.

Technical Assistance

Three major “risk-on” rallies have occurred since the 2007-09 bear market ended. The first started in 2009 and ended in late April of 2010. The second started in July 2010 and ended when the S&P 500 peaked in May 2011. The third began last October and remains in force. Although stock prices can surge during these risk-on rallies, these mini bull markets have been punctuated by periodic corrections and pullbacks.

The price history of the S&P 500 highlights some of the key technical indicators on my radar.


As you can see, the stock market pulled back sharply in February 2010 and again in February and March 2011. This pattern won’t necessarily hold in 2012, but the S&P 500 looks overextended at current levels and is approaching a key point of resistance, which increases the risk of a correction.

The Relative Strength Index (RSI), which measures the extent to which the stock market is overbought or oversold, is well above the level at which the stock market is considered overbought. In addition, the S&P 500 trades well above its 50-, 100- and 200-day moving averages. At current levels, the S&P 500 is even further above these key moving averages than it was one year ago.

At the same time, the S&P 500 is butting up against a major resistance level: the index’s 2011 high. Investors who bought stocks early last year are close to breaking even and may be looking to sell after regaining their losses.

Alternatively, a trader who bought the market in the fourth quarter of 2011 is sitting on substantial gains and is probably looking for an excuse to take some profits off the table. After all, in each of the past two years, investors who held too long watched their gains evaporate in a matter of weeks when the market sold off in the summer.

That brings me to the question of how far a potential correction might go. Often, the 50-, 100- and 200-day moving averages act as supports during market corrections–that was the case during the February 2010 and 2011 pullbacks. If this pattern holds in 2012, expect the S&P 500 to correct to between 1,250 and 1,280–about 5 percent to 8 percent from current levels.

Let me make one point clear: I am not calling for the market to peak and break sharply lower. In fact, I expect the S&P 500 to eclipse 1,400 sometime this spring. However, the risk of a short-term pullback that could persist for two weeks to four weeks is rising.

The bad news: Timing such a pullback exactly is next to impossible. The market is overbought, but stocks can stay overbought for weeks without a significant correction. In fact, by definition, the most profitable market rallies are characterized by stocks staying overbought. A short-term pullback is inevitable, but I can’t tell you whether it will start today or a month or two down the road. Investors who perennially try to pick a top end up sitting out on these moves. Liquidating your positions because the market looks overextended isn’t a viable strategy.

But you can take steps to protect yourself. Last week, I advised readers to take partial profits on stocks that have run up the most. For example, energy-related stocks have performed particularly well of late; in a Flash Alert to readers of The Energy Strategist, we took partial profits on two names that had rallied substantially in recent months.

It’s often said that two emotions drive the market: greed and fear. With fear in the driver’s seat last summer, good stocks were hammered because investors were scared and fled riskier asset classes. At the San Francisco MoneyShow in early August 2011, investors struggled to accept the idea that the selloff marked an outstanding buying opportunity, especially for Linn Energy LLC (NSDQ: LINE), Enterprise Products Partners LP (NYSE: EPD) and other names that offer higher yields and sustainable quarterly distributions. Investors who overcame this fear were rewarded.

The current market is driven by greed. Don’t get caught up in the euphoria and overpay for stocks. Some of my favorite names trade at levels where they’re vulnerable to a pullback. Keep some powder dry–a short-term correction would mark an attractive entry point.