After the pullback in July and a small pullback in September, the S&P resumed its rally in early October as the third quarter earnings season was getting underway. There was quite a bit of skepticism about the earnings season and whether companies would be able to meet the expectations of investors as the trade war has raged on for almost two years now.
For the most part, companies have impressed investors enough to drive stock prices higher and as a result, the S&P 500 has experienced a six-week rally that has allowed the index to set to new all-time high closes in each of the last three weeks prior to this week. Unfortunately, the rally has also caused one of the overbought/oversold indicators to reach overbought territory. Since the trade war started, when the 10-week RSI has reached overbought territory, a pullback has followed. The depths of the pullbacks have varied greatly, but the indicator has not remained in overbought territory for very long.
We see that the RSI hit the overbought territory in August and September of 2018, just before the major decline in the fourth quarter of last year. The first quarter rally brought the RSI back up to the 70 levels in April and then we saw a minor pullback that saw the S&P lose nearly 7% in the month of May and into the first few days of June. In mid-July, the RSI flirted with the 70 level again and then fell 6% in a few short weeks in late July and early August.
At the end of last week, the RSI once again closed above the 70 level and now we are seeing a little selling pressure this week. Is this the start of another pullback? It certainly looks like it is possible. If the S&P does pullback, how much it falls is anyone’s guess, but based on the pullbacks over the last two years, it might prudent to take some profits off the table.
I’m not suggesting that investors jump out of everything, but rather that if they have stocks that are up substantially in the last three to six months, it might be prudent to sell some of their shares to protect the gains. I know in the Hedged Alpha Strategy that I run on Seeking Alpha, I have recommended taking profits on a few stocks in the last couple of weeks. I didn’t recommend closing the whole position, but rather I recommended closing a portion of the position.
If the market continues to move higher, we still have some exposure in the stocks that have performed well and we are adding a new position each week. So it’s not like we are jumping completely out of the market, we are just protecting some of the gains that we have.
Another factor in my recommended profit-taking is the overall sentiment in the market. The Investors Intelligence Bull/Bear ratio dropped to 2.77 back on October 8 and that was the second lowest reading since the big drop last December. The ratio has now jumped back up to 3.35 and is closing in on its highest reading of this year.
The AAII Sentiment Survey showed a bearish percentage of 44% back on October 8 and a bullish percentage of 20.3%. The readings from last week showed a bullish percentage of 40.7% with a bearish percentage of 24.8%.
While these sentiment readings aren’t necessarily extreme, the rapid change shows how quickly investors have jumped back into the bullish camp. Personally I like to look at the overall levels for extreme readings, but I also like to watch the trend. When I see big changes in the overall sentiment, it causes a concern that investors are changing their posture too quickly and can be a sign that a pullback is about to occur.
My recommendation is to be a little more cautious in the coming weeks.