Indicators Suggest Time for Caution

The market has had a good run off the March lows. It has defied some pretty ugly news, made it through the brunt of earnings season, the FOMC rate decisions and key economic reports. The rally from the low has been in the neighborhood of 13%, so not too shabby.

However, it hasn't been quite as easy as that performance number would suggest, and it never is after a high-profile, energetic and steep decline. This move has been led by the basic materials and energy, as the worldwide growth story remained intact and the slowdown in the U.S. did not impact the economic situation of the emerging market countries.

So, this brings us to the next big question: Now what? While we ask this question to some degree each day when we view it from a slightly longer time frame or more macro view, we occasionally find the market positioned at a more important transitional period.

The market, as measured by the major indices, is at the next transitional point. Thanks to the rally from the lows, the S&P 500 is at the next key resistance level in the declining 200-day moving average, and the downtrend that has been in place since the market peaked in October 2007. Simply based on the price action, the market is at a point that will either change the complexion of the market from down to something else, or the downtrend will resume.

We can add to those headwinds our infamous intermediate-term SARSI indicator which has reached overbought levels for the first time since, well, October of 2007 when the market peaked. This doesn't mean there is an immediate pullback coming or that the rally is over, but it certainly has had a good run and is potentially running out of steam.

Historically when we have seen these levels reached, it is suggestive of the broadest part of the rally having occurred and a narrowing happens, making stock selection even more important. This is also the level from which we see corrective moves and pullbacks begin.

You might be asking how it's possible the market is back to intermediate-term overbought levels when so many stocks are still mired in downtrends. The answer is most have had oversold bounces that have pushed the indicator to overbought without changing the negative character of most stocks. That is, in essence, the definition of a bear market rally.

S&P 500 Depositary Receipts

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We believe it's prudent to get more cautious here. The easiest way to do that is be hedging or putting on some exposure that would benefit from a pullback. In that regard, shorting the S&P 500 Depositary Receipts (SPY - commentary - Cramer's Take) would be the easiest and most direct way to benefit should weakness develop. This is a low-risk proposition and something we can do with a tight stop. It might be possible for traders to get short the SPY at current levels and stop out on a move above the 143-45 resistance.

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At the time of publication, John Hughes and Scott Maragioglio were short the S&P 500 Depositary Receipts. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.