6 Charts That Suggest a Market Top

02/07/2012 9:15 am EST

Focus: STOCKS

J.W. Jones

Chief Options Strategist, Technical Traders, Ltd.

Several indicators are suggesting that the stock market has reached extreme overbought levels, and given recent price action in gold and the US dollar, a pullback (and new buying opportunity) may soon unfold.

Late last week, traders and market participants awaited the key January employment report from the US Bureau of Labor Statistics. The reaction to the supposedly wonderful report was a surge in the S&P 500 E-mini futures contracts as well as several other key equity index futures.

The overall tenor among the financial punditry was predictable, as wildly bullish predictions permeated the morning session on CNBC and the financial blogosphere. However, after the report had been out for several hours, notable independent voices such as Lee Adler of the Wall Street Examiner came out with information that suggested the numbers were an apparition of manipulated statistics.

I am not going to spend a great deal of time discussing the report, but the reaction to the news was decisively bullish on Friday. The question I want to know is whether Friday was a blow-off top? In the recent past, the S&P 500 has seen several key inflection points and intermediate-term tops form on non-farm payroll monthly announcements.

I follow a variety of indicators to help me decipher more accurately when the market is getting overbought or oversold. For nearly two weeks, the market has been extremely overbought, but now we are reaching truly astonishing levels. The following charts represent just a few signals that the market is due for a pullback and a top is likely approaching.

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The chart above clearly illustrates that as of Friday’s closing bell (Feb. 3), over 89% of stocks were trading above their 50-period moving averages. Consequently, that reading is one of the highest levels that we have seen in the past three years.

In addition, over 73% of stocks that trade on the NYSE are currently priced above their longer-term, 200-period moving averages. That’s another extremely overbought signal.

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The S&P 500 bullish percent index is another great tool for measuring the overall position of the S&P 500. It is without question that the longer-term time frame is reaching the highest level of overbought conditions in the past three years.

McClellan Oscillator Divergence with S&P 500 Price Action

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The two charts shown above present an interesting situation regarding the divergence in the McClellan Oscillator and the price action in the S&P 500. The most recent example of this type of divergence occurred in October 2011, and prices immediately reversed to the upside after several months of selling pressure. In fact, this correlation between reversals in the S&P 500 and divergences in the McClellan Oscillator works relatively well, historically.

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Clearly, there are bullish voices arguing for the 2011 S&P 500 index high of 1,370.58 to be taken out to the upside in the near future. Additionally, several market technicians in financial blogs have been pointing to the key resistance range between 1,350 and 1,370 on the S&P 500 as a likely price target. Obviously if those price levels are met, strong resistance is likely to present itself.

However, as a contrarian trader, I have found that the more obvious price levels are, the more likely it is that they either will not be tested or they will not offer significant resistance.

It is obvious that Fed Chairman Ben Bernanke and the Federal Reserve have embarked on a massive fiat currency printing campaign, which has helped buoy risk assets to the upside. Through a combination of reducing interest rates on safe-haven investments like Treasury’s and CD’s, the Federal Reserve has forced conservative investors and those living on a fixed income into riskier assets in search of yield.

This process helps elevate stock prices and creates the desired outcome for the Federal Reserve, which involves the perception by average individuals that they are wealthier. The Fed calls this the “wealth effect,” and they seem poised to insure that US financial markets continue to ride upon a sea of cheap money and liquidity.

Ultimately, the Federal Reserve’s most recent announcements have served to help flatten the short end of the yield curve further while providing a launching pad for equities and precious metals. However, issues persisting in Europe could have an adverse impact on the short- to intermediate-term price action of the US dollar.

Right now, everywhere I look, I hear market prognosticators commenting on how hated the US dollar is and how Chairman Bernanke will not allow the dollar to appreciate markedly in order to protect US exports and financial markets. I think that the dollar has the potential to rally in the short to intermediate term. Right now, the US dollar index appears to be trying to form a bottom.

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Obviously, there is good reason to believe that the US dollar index could reverse to the upside here. Whether it would have the strength to take out recent highs is unclear, but a correction to the upside not only seems unexpected by most market participants, but it seems plausible based on the weekend news coming out of Greece.

On Monday morning, the Greek government was set to determine if they will agree to the demands of the Troika in exchange for the next tranche of bailout funds. If the Greek government and the Troika do not come to an agreement, the euro could sell off violently.

Additionally, there are already concerns about the next long-term refinancing operation (LTRO) from the European Central Bank. The measure is to help provide European banks with additional liquidity, but there are growing concerns that the size and scope of the LTRO could have a dramatic impact on the euro’s valuation against other currencies. Time will tell, but there are certainly catalysts which could help drive the US dollar higher.

Another potential indicator that the dollar could see higher prices in coming days was the largely unnoticed bearish price action on Friday of precious metals. Both gold and silver have been on a tear higher over the past several weeks. Both precious metals have surged since the Federal Reserve announced that interest rates would remain near zero on the short end of the curve through 2014.

However, on Friday, gold and silver were both under extreme selling pressure, and the move did not get much attention by the financial media. The price action in gold and silver on Friday could be another indication that the US dollar is set to rally. The daily chart of gold is shown below.

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Obviously, the reversal on Friday in gold futures was sharp. The move represented nearly a 2% decline for the session on the price of gold. However, as long-term readers know, I am a gold bull. I just do not see how gold and silver do not rally in the intermediate to longer term based on the insane levels of fiat currency printing going on at all of the major central banks around the world. The macro case for gold is very strong, but the short-term time frame could reveal a brief pullback.

At this point, I suspect a pullback will present a good buying opportunity for those who are patient. However, I think it is critical to point out that this move in gold on Friday could be a signal that the US dollar is going to find some short- to intermediate-term strength. If the dollar does start to push higher, it will likely put downward pressure on risk assets like equities and oil.

While Friday’s price action may not mark a top, nearly every indicator that I follow is screaming that stocks are overbought across all time frames. Pair that with the Greece uncertainty and LTRO considerations and suddenly the dollar starts to look a bit more attractive. Ultimately, I am not going to try to pick a top, but the evidence suggests that it might not be too many days/weeks away.

By JW Jones of OptionsTradingSignals.com

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