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S&P 500 Strained, Time to Head to the Sidelines

Apparently the secret formula for bullishness is quantitative easing. Never mind the fact that the Fed’s decision to (further) lower interest rates doesn’t directly create jobs, nor does it prompt a bank to suddenly determine a potential borrower is more credit-worthy.  The market just wanted to see evidence that the Fed was ahead of the curve, and Bernanke delivered. Boom - stocks gained 3.6% last week, most of it on Thursday.

But is there any longevity to the uptrend? Bluntly, you’d be hard-pressed to even call it a trend. It was more of a one-hit-wonder that just happened to drive the market further into an overbought situation. But hey, the market’s rallied right through worse.

What is there to say about the S&P 500 that would mean much in the way of an outlook? Last week was all about the Federal Reserve inducing a rally. Fundamentals didn’t matter. Earnings didn’t matter. Technical momentum - or lack thereof - didn’t matter. The market pretty much demanded Bernanke do something, and he obliged. The question from here is, how much mileage can stocks get out of what should largely be a pointless action (QE) from the Fed?

Unfortunately, the answer is “not much” if previous emotionally-driven rallies are any clue. At some point the market has to justify its value.

In any case, the gravy train may have already stopped, with the S&P 500 back at the upper Bollinger band (purple) that’s been such a problem going as far back as early 2009.

On the other hand, we need to at least acknowledge that the upper band line isn’t necessarily a bearish reversal point - it may only be the area where the incredible rally slows down…. like we saw in October.

Simultaneously, the VIX stopped its downward move at its lower Bollinger band, suggesting confidence in the rally at this point is low.

So a pullback is in the cards? We’re due a pullback, but we were due a pullback in late October and the S&P 500 continued to rally anyway. [As John Maynard Keynes said, "The market can stay irrational longer than you can stay solvent."] So, as for how to proceed from here…

The market is overextended now no matter what; look for a pullback to some degree early this week. How far? That depends.

Until the 20-day moving average line (blue) at 1185 - and rising - breaks down as support, there’s no valid reason to assume the implosion is nigh. Of course, after the 16% runup since September’s low, any implosion could be a hefty one when and if it gets rolling.

On the flipside, don’t rule out more upside. If a small retreat can cool the rally off enough to bleed off some of this overbought pressure (a dip to the 20-day line would do the trick), the bulls could regroup and restart the uptrend pretty nicely.

The last thing the bulls want to see happen here, however, is for the market to pop even just moderately above the upper Bollinger band. Such a move could be interpreted as a blowoff top…. a last hurrah, of sorts. Be leery of such a move,

In the meantime, the market’s in limbo. You may want to stay on the sidelines until we get a little more clarity.

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James Brumley is a freelance writer and registered investment advisor. He began his career as a broker with a major Wall Street firm, where fundamentals and long-term holding periods were core strategies. After that, he switched gears completely, becoming an analyst at a short-term trading newsletter that focused on technical analysis. He now manages client money using the best of both philosophies. His company, Bluegrass Portfolio Management, offers investors an opportunity to reap superior returns with minimized risk.