U.S. equities have defied their usual seasonal weakness this summer.
The Dow Industrials and S&P 500 recently rose to all-time highs. But now, investors are beginning to question whether this is still a healthy bull market with more room to run, or whether it’s on its last legs.
A technical indicator I consult daily may have the answer. It’s called the NYSE McClellan Oscillator (symbol: $NYMO). This so-called breadth indicator measures the difference between the number of advancing and declining shares on the New York Stock Exchange to determine whether the market is overbought or oversold.
|A technical indicator I consult daily is waving a red flag for stock-market bulls.|
Anything under minus-40 (see chart below) indicates that stocks are oversold, and the market is bottoming. Conversely, when the McClellan Oscillator breaks through plus-40, it is an indication that stocks are overbought and a market top may be nearing.
Timing the Market
Typically, the NYSE McClellan Oscillator and stock prices have a high positive correlation. In other words, the indicator’s peak and trough signals tend to occur in concert with the broad indexes, give or take a few days. So, historically, when the Oscillator breaches minus-40 to the down side, we can expect stocks to bottom and soon begin to head higher. And when it rises past plus-40, the smart money bets that a new downtrend will begin shortly.
Still, the relationship between the McClellan Oscillator and major U.S. stock indexes broke down earlier this year. In early May, the indicator topped plus-40, signaling that stocks were overbought. But the S&P 500 continued to rise for another three weeks — and nearly 50 points!
As you can see from the chart, we’re facing similar conditions now. The McClellan Oscillator surged past plus-40 early this month, topping out July 8 at nearly plus-70, the highest in more than a year. But stocks have kept climbing higher.
Investors have taken heart from Chairman Ben Bernanke’s comments that the Federal Reserve’s monetary policy will remain accommodative for the foreseeable future. And they seem to be buying on every bit of news, from improving European manufacturing, to optimism on more government stimulus in China, to higher copper prices, to better-than-expected corporate earnings.
Equities Are Peaking
Given this bullish sentiment, investors can’t be faulted for discounting the McClellan Oscillator’s warning signal. But because I watch this technical indicator closely, I must point out that this trading pattern is beginning to look uncannily similar to the market top in May.
At the time, the market continued to increase for three weeks and nearly 50 points beyond the point at which the McClellan Oscillator surpassed the plus-40 mark. We are now almost three weeks past the July 8 top on the indicator, and roughly 50 points higher than the S&P 500 was then.
Of course, this can’t prove that stocks are about to tumble. No single indicator has a perfect record at predicting trends. Moreover, if the Federal Reserve continues to prime the pump, there’s no telling how long this rally can continue.
But make no mistake: This is a red flag for stock-market bulls. The McClellan Oscillator tells me that equities are overbought, and the market has peaked. Those of you invested in shares would be wise to do as I do and check in on this important indicator every day.