Is the Market Ready to Roll Over? These Signs Say Yes

Stock market trader
Stock market trader

The U.S. stock market has been on a tear since Sept. 1, but technical caution flags are now appearing in the charts. They're signaling that the market may be about to roll over.

For a technical snapshot, let's turn to one of the more reliable indicators, the VIX Volatility Index, and then examine charts of three key indexes: the broad-based S&P 500 (SPX), the big-tech-dominated Nasdaq 100 ($NDX) and a widely known exchange-traded fund, Financial Select Sector SPDR Fund ETF (XLF).

The VIX operates as one end of a see-saw, with equities on the other end. When stocks are rising to new highs, the VIX is plumbing the depth; when stock are cratering, the VIX shoots up.

This is clearly visible in the chart: The VIX spiked to 80+ during the global financial meltdown of late 2008 and then fell to lows around 15 at the market's high point in late April, 2010.

That signaled extreme complacency, which generally sets up a reversal and a return to volatility. Interestingly, the key indicators of MACD (moving-average convergence/divergence) and stochastics have fallen to levels not seen since late April -- right before equities fell into a three-month swoon.

This return to complacency is at odds with the actual risks facing the global economy: Eurozone debt issues, currency wars and the foreclosure/mortgage crisis, which is already hurting the U.S. financial sector.

Interestingly, although the stochastic indicator has reached the same low notched in late April, the VIX has not fallen to the April lows. That establishes a "higher lows" uptrend, suggesting the possibility that volatility may be slowly rising in the background.

The low VIX is flashing a very strong caution signal to participants eerily similar to the warning it issued in late April 2010.

Big Tech Names Lead the Nasdaq

Another way to assess market strength is to look for broad-based bullish action and rising volume. Unfortunately for the bulls, caution flags are flying here as well.

One way to look at the relative strength of large-cap technology names such as Apple (AAPL), Google (GOOG) and Amazon (AMZN) is to look at the Nasdaq 100, which is dominated by the big tech companies.

As we see on the chart, this tech-heavy index recently notched a new high, and some technical indicators such as MACD are still undeniably bullish. But signs of weariness are evident even here: The stochastics are toppy and threatening to roll over, volume is still significantly lower than in April and the 20-day moving average (MA) has converged on the 50-day MA, signaling a weakening short-term trend.

On a more positive note, the two moving averages are still rising, and the index is well above the long-term support of the 200-day moving average.

The chart of the broader-based S&P 500 isn't quite as rosy, and that suggests a narrowing of leadership in the market. This is worrisome to observers who recall the early days of 2000, when a few big tech stocks were powering the entire market higher. A few months later, when the "Four Horseman" leaders finally rolled over, equities cliff-dived into a savage multiyear bear market.

The SPX chart is chockful of cautionary signs. Where the NDX climbed above its 200-day MA back in late 2009, the SPX has yet to surmount that key technical resistance. The bullish cross registered in August 2009 when the 20-day MA crossed above the 50-day MA has been countermanded by a negative cross in August 2010, and volume is still far below the highs of April, suggesting tepid demand for equities. While volume has notched higher, it doesn't align with the breathtakingly steep rally since Sept. 1.

The indicators are also bearish: The stochastics have rolled over, and the MACD has been in a downtrend since April, having barely breached the neutral line.

Financials Are Looking Sickly

Leadership in the market is often like a baton being passed from one sector to the next, but technology and the financial sector are generally viewed as providing solidly bullish leadership. With that in mind, let's look at the financial sector ETF XLF.

This chart reflects the sickly technicals of financial stocks. Volume has markedly decreased, and both MACD and the stochastics are in downtrends. The 20-day moving average has slipped below the 50-day moving average, indicating a reversal of the uptrend. And rather ominously, price action has traced out a flag or wedge: lower highs and higher lows.

Wedges tend to break up or down in a big way as the indecision implicit in the chart is decisively resolved one way or the other. With banks facing legal limbo in mortgage foreclosures and potential lawsuits on multiple counts, it stretches credibility to expect the financials to reap rip-roaring profits in the coming quarters. More likely, banks will suffer declines in revenues and rising costs, crimping future profits.

Technically, lots of dead air is under the current price level, and if the XLF sags into a downtrend, then its impact on the broader market will likely be negative.

Can a handful of tech companies like Apple, Google, Amazon and Priceline (PCLN) keep the broader market aloft? History suggests a market dependent on a narrow leadership is vulnerable to reversals.

Disclosure: The author owns puts on the XLF.