A Creeping Caution on Wall Street

Institutions have recently started taking profits in highflying sectors -- and moving back towards the defensive areas of the market

by Mark Arbeter From Standard & Poor's Equity Research

The stock market paused last week as the major indexes dealt with resistance as well as overbought conditions. Bond yields remained in a very narrow range while crude oil continued to oscillate in the high $50s area.

While the broad market took a break last week, the recent rotation into consumer discretionary and technology stocks, and out of defensive areas like staples, utilities and pharmaceuticals stocks reversed, at least for the short-term. This rotation between sectors and subindustries is one of the key drivers that are keeping a floor under this bull market, in our view, as money constantly finds a home in U.S. equities.

The S&P Consumer Discretionary sector has been on a tear of late, rising 17.1% from July 21 to October 12. The S&P Information Technology sector surged 21.6% from July 21 to October 16. The S&P Retail Index rose almost 21% while the Philadelphia Semiconductor Index jumped 23.5%. During part of this time, from August 2 to September 20, the S&P Energy sector was weak, dropping 12.1%.

While the higher beta, more aggressive stocks were running, the S&P Consumer Staples sector rose less than 7% from July 14 to September 20. From September 20 to the recent low on October 2, the Staples sector fell almost 2%.

However, this week, institutions started taking profits in the highfliers and moved back towards the defensive areas of the market. The Amex Pharmaceutical Index broke out to a new multi-year high this week, and is up almost 3% since October 11. The Dow Jones Utility Index broke out to an all-time high this week while the S&P Consumer Staples sector started headed back up and looks to be working on the right side of its base. Meanwhile, the higher beta stocks look toppy after their huge run, with the S&P Retail Index falling over 2% in the last week and the SOXX index down over 6% since October 16.

We believe some of the profit taking in discretionary and technology is simply rotation back to energy stocks as the S&P Energy Index has gained almost 8% since September 20. Since the April/May period, investing has become a series of rapid rotations from defensive to growth, and that may be happening again, to the benefit of the defensive stocks. In our view, this creates excellent opportunities for nimble investors to buy oversold groups and sell overbought groups.

Meanwhile, the major stock market indexes have run into a myriad of resistance levels, while being fairly overbought on a daily basis. The S&P 500 is currently dealing with at least 3 pieces of resistance, two short term and one long term. Short-term trendline resistance off the recent highs since mid-August is at 1370. The 21-day price envelope sits just above the 1370 level. Long-term trendline resistance, off the peaks since early 2004, is right at 1365. On October 16, the 14-day relative strength index (RSI) almost hit 75, the highest since November 2004. Anything above 70 on the 14-day RSI is considered overbought. The 6-day RSI was over 82 on October 16, and this is also considered fairly overbought.

While the S&P 500 is overbought on a daily basis, there have not been any negative divergences with respect to the RSI or MACD indicators. This leaves us believing that the index has yet to peak from an intermediate-term perspective.

The Nasdaq has basically retraced the entire 15% correction it endured from April to July. The recent closing peak on October 16 was 2363.84, very close to April's closing high of 2370.88. After a strong recovery back to old highs, stocks and indexes have a tendency to pause/pullback before breaking to new high ground. A strong break above the April high could set the Nasdaq up for a run to the top of the channel that has been in place since 2004 up near the 2500 level. The next Fibonacci target, assuming a breakout above 2370.88, would be 2587.48. Multiplying 0.618 by the width of the correction, and then adding the product to the breakout point gives us this potential target.

Like the "500," the Nasdaq is also overbought. The 14-day RSI recently hit 75 while the 6-day RSI got up near 84.