After a period of calm and tranquility, with geopolitical chaos being set aside as investors focused on better-than-expected second quarter earnings, volatility made a comeback on Friday as the Dow Jones Industrial Average tested below its 20-day moving average.
A close below this level represents the break of an unblemished uptrend going back to May. And with it, the feeling of invincibility that Wall Street has been enjoying.
How else can you explain the speculative frenzy and pure momentum chasing that boosted Cynk Technology (CYNK) to a $6 billion market capitalization for a company with no revenue, no serious business plan, and a single employee running around somewhere in Belize? Or the short squeeze in Herbalife (HLF), a company that is clearly questionable? Or the rebound in biotechnology stocks after the Federal Reserve warned of stretched valuations?
Measures of investor sentiment, portfolio positioning, margin debt, and valuations have all become extended and vulnerable to a correction. Sure, the bulls will say the cyclically adjusted S&P 500 price-to-earnings ratio is within historical norms. But it's at levels that have only been exceeded in 1929, 2000, and 2007.
While folks have been quick to dismiss the situations in Ukraine, Iraq, and Israel, a number of new catalysts next week won't be so easily ignored.
These include the conclusion of the Federal Reserve's two-day policy meeting on Wednesday, which will further wind down the ongoing "QE3" bond purchase stimulus program. We have the initial reading on second quarter GDP, which will be critical after the very soft result in the first quarter. And we have the July jobs report on Friday, which if strong would bring forward estimates of the first Fed short-term interest rates hike into early 2015.
Once the fever of overconfidence is broken, investors will notice that the market isn't as strong and robust as it appeared on the surface. Market breadth -- a measure of how broadly stocks are participating to the upside -- has been weakening for weeks. The percentage of NYSE stocks above their 50-day moving average has dropped to around 60 percent from a peak of more than 83 percent at the start of July.
Just focusing on the 30 components of the Dow Jones Industrial Average tells the story. A growing number of stocks on the list are rolling over. General Electric (GE) is set to close below its 200-day moving average for the first time since February. American Express (AXP) looks set to close below its 50-day moving average for the first time since May. Boeing (BA) has dropped to levels not seen since April. Caterpillar (CAT) has broken an uptrend going all the way back to November.
And United Technologies (UTX) -- an industrial sector stalwart -- has collapsed below its 200-day average on a scale that hasn't been seen since 2012.
Yet the Dow is now merely testing its 20-day average while the market overall hasn't suffered a 10 percent correction in more than 1,000 days. We're overdue. Given all this, plus indications that diplomatic efforts in Ukraine and Israel are failing to bear fruit, investors should start preparing for fireworks in the days and weeks to come -- because as I explored in a recent post, it looks like professional traders already are.
Disclosure: Anthony has recommended put option positions against GE to his clients.
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