An Orderly Correction, So Far

05/16/2011 1:24 pm EST

Focus: MARKETS

John Bollinger

President and Founder, Bollinger Capital Management

Weakness among midcap and small-cap issues is one of the few red flags raised by the current pullback in equities, writes John Bollinger in the Capital Growth Letter.

There has been a lot of talk about the recent surge in bullish opinion and how bad that is for the market, so I had a detailed look at the recent Investors Intelligence numbers and was frankly a bit surprised by what I found.

I took the past 30 weeks of survey numbers and calculated the averages for the percentage of bullish advisors, bearish advisors, and advisors expecting a correction.

It turns out that over that time we have seen a hardening of positions, rather than an overall increase in bullishness. Bulls are currently 1.7% above their 30-week average and bears are 2.5% above their average, while the prevalence of those on the fence has fallen by 4.3%.

This actually feels more like what is happening—while bullish opinion has been rising, both bulls and bears are becoming more strident, which has led to more volatility as they argue their positions in the market with each news release.

Before you let the bears overwhelm you with their rhetoric, please note that the stock market continues to make a series of higher lows. With the market pulling back in the post-bin Laden era, the first thing we check is the market internals:

  • First, the advance-decline line made a new high with the market, so we have no immediate breadth divergence to worry about. In the subsequent decline, the A-D line simply echoed price, and has not led to the downside.
  • Second, while new lows have expanded a bit, it is only a very slight expansion and much less than might have been expected.
  • Third, we checked the relative performance of midcap and smaller stocks and they have not fared well, so this is our first cause for concern and the first factor we will be watching when the market mounts a return rally.

Speculation Masks Real Growth
Another factor on our watch list are knock-on effects from the declines in silver, gold, and crude, which is perhaps best said as troubles caused by the pullbacks in commodities. Commodity prices are a double-edged sword, with good and bad sides to both the advances and declines.

Interestingly, the pullbacks in industrial commodities are relatively mild, which says to me that the high-flying commodities were bubbles mainly caused by expansive monetary policy, not real industrial demand, and that the underlying economy continues to grow.

The first thing that I see in our proprietary sector rankings, based on both technical and fundamental considerations, is that energy is washed over the short-, medium-, and long-term horizon. That doesn't mean that the decline is at an end, but it does mean that it is time to prepare shopping lists, so when a bottom occurs we can add to positions in a sector that we regard as an important long-term hunting ground.

Also of note: industrials are approaching a similar position, and I think that this will be another great source of ideas that will be carried forward by the continued economic expansion.

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