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After falling sharply at the end of 2015 and beginning of 2016, the S&P 500 index stormed back with five straight weekly gains. From my perspective, it looks like that five-week S&P 500 rally has run out of steam and we could see another leg down for the index.
First, looking at the daily chart for the index we see very similar patterns in October and November and again in February and March. Look at the two boxes I have drawn. We see that the index moved above its 10-day moving average and then stayed above that moving average for approximately five weeks. The rallies both took place after a double-bottom pattern formed and provided the support for the bounce.
We also see that the oscillators look very similar during the two rallies, as the daily stochastic readings remained in overbought territory for an extended period, as did the 10-day RSI. After the rally ended in November, the index moved sideways for the better part of two months before it fell sharply.
Turning our attention to the weekly chart, we see a slightly downward-sloped trend line connecting the highs from the past year. We also see that the index is currently dancing around its 52-week moving average.
The weekly oscillators offer two more reasons to think that the rally is over. The 10-week RSI hit the 55-60 range, which is as high as the indicator has gotten in the last 15 months. The weekly stochastic readings moved back into overbought territory this week.
There are a couple of other factors behind my cautious outlook. First, the CBOE Volatility Index (VIX) has fallen sharply in the last couple of months. After hovering around the 27 level for a few weeks at the beginning of the year, the VIX dropped by half by mid-March. It did the same thing from August through the beginning of November last year, right before the sideways move in November and December.
Yet another factor is the Shiller P/E Ratio falling back below the 25 level. For those of you not familiar with the Shiller P/E Ratio, it measures the price-earnings ratio of the S&P 500 on an inflation-adjusted basis. From 2004 through 2007, the Shiller P/E Ratio was above 25, but then moved below 25 in January 2008. With the next earnings season getting ready to kick off when Alcoa (NYSE: AA) reports on April 11, this is definitely something to keep an eye on.
Based on the daily and weekly charts for the S&P 500 – as well as the current levels of the VIX and Shiller P/E Ratio – I think investors have to exercise caution at this time. The rally has caused investor sentiment to shift from cautious to more optimistic – or at least that is what the drop in the VIX suggest.
I recommend that investors take action to protect their portfolios, such as buying some protective put options, moving a portion or your portfolio out of equities or adding an inverse ETF that will rise when the market falls. Regardless of your preferred method of hedging, I recommend you do it.
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