Stock Market Rally Lacks Volume Ready to Correct

A healthy bull run for the stock market must come from rising prices and rising volume. This is an old and time-honored stock market analysis concept, and probably one of the most profound insights into market behavior.

Thus, a rally lacking volume is at least suspicious. And a rally with declining volume is a sign of a weak market and usually a harbinger of a correction if not an outright trend change.

Have a look at the S&P 500 chart below. As you can see, the whole rally off of the March 2009 low is characterized by low volume. Hence, I see a high probability that this bull run will finally end and prove to be just a huge bear market rally.

Especially Weak: The Rally Since November 1

Now take a second look at the above chart. The rally since the late October low was especially weak. Volume was not only miniscule, it was also declining markedly. This tells me that the recent break out in prices to new highs for the year was on very thin ice.

Additional weakness comes from the advance-decline line and momentum indicators. Neither has confirmed these new market highs. In fact, they’re actually showing negative divergences! This is a typical sign of a weak market ready for a correction.

Finally, sentiment indicators got frothy when some of the major stock market indexes reached new highs for the year. The chart below shows advisory sentiment as published by Investors Intelligence …

As you can see, stock market bulls reached 50.6 percent of all newsletter writers, and the number of bears tumbled to a paltry 17.6 percent. Thus the bull-to-bear ratio jumped to 2.9. This is a very high figure, often associated with an interim stock market high.

All in all, the technical and sentiment indicators are in a position very typical for a market at risk. So I think we may soon get another marked correction, probably down to the October lows or even a bit lower.

And beyond the technical picture, there is also a major fundamental reason to be wary right now. Namely, that …

The Major Debt Problems Have Not Been Solved

The news of the financial woes in Dubai should remind investors that the major debt problems associated with the global real estate bubble have not been solved. So over the next two years I expect that we’ll hear from many more defaulting borrowers in and outside the U.S.

The financial crisis in Dubai is sending a clear message.

And to make matters worse, governments’ reactions to the first act of this huge crisis has only aggravated the problems by shifting the risks from private entities to public ones.

It’s too early, however, for this second act to get started. I expect it’ll begin during the second half of 2010, when a new wave of mortgage resets starts hitting the U.S. banking system. And it will probably be as severe as the subprime reset wave was.

It’ll be very interesting to see how the governments around the globe react …

Some may still be strong enough to throw hundreds of billions of tax payers’ dollars at the problem again and start another round of insane and myopic policies. But others, the weaker ones, may find themselves trapped, not being able to absorb a new surge of losses.

Consequently, instead of only banks going bust we may well see banks plus some governments going bust!

But all that is in the future. Not yet. Dubai is just telling us not to forget the important things going on behind the scenes of this huge stock market and economic bounce thanks to the strongest peacetime stimulus in history.

And the technical picture is telling us that a correction could be in the cards, too.

For now, I would treat any potential stock market weakness as a buying opportunity since I don’t yet see an end to the medium-term up trend that started in March.

But we should never forget the long-term risks, either.

Best wishes,

Claus

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