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Market Vulnerability May Be Overstated for Now

Several indicators appear to suggest that the market may be in store for a sharp, rather painful correction. Negative divergences are implying that the move to the upside cannot continue.

Breadth, while moving higher faster than the S&P 500, has yet to surpass its February highs like the S&P 500.¿ The number of stocks making new highs has not risen with the advance/decline line, resulting in a bearish negative divergence for the market.¿ The sentiment indicator I use is still below 50% bullish, which is considered the line to be crossed for the indicator to be negative for the market.

From mid-March through mid-April, in the first several weeks of the rally, the market was characterized by lagging breadth, which is described in several ways.

The most common indicator used to describe breadth is the cumulative advance/decline line. Last month I wrote about this indicator and emphasized its lagging nature as not being a bullish aspect of the market. However, about one week ago, in early May, that changed. The market went from the big-cap averages leading the way to the upside, to breadth leading the way to the upside.

In the chart above I use the cumulative advance/decline line for the NYSE but only with common stocks. There are no ETFs, closed-end funds, preferreds or anything that is not an operating company. Note the way in the past week the breadth line has surged, much more than the S&P has. By that I mean the S&P has just eked out a higher high this week while breadth has spurted well beyond the highs it had last week. This is bullish action.

However, if we step back and look at the big picture, we can see that the S&P has now cleared the highs made in February by a decent margin, but breadth is still below the February highs (circled in red on the chart).Negative Divergence with New Highs

Another measure of breadth is the number of stocks making new highs. Thus far, the NYSE has seen its peak reading of stocks making new 52-week highs back on April 18. That day, we saw 156 stocks making new highs. The S&P was at 1390 back then; today it stands around 1420. So we've added 30 points, or about 2%, to the S&P, and the number of stocks making new highs has held steady.

So consider this: The cumulative advance/decline line has surged in the past week, meaning the average stock has outperformed the major averages, yet there has been no increase in the number of stocks making new highs. We would consider that a negative divergence.

What we have on our hands in this market is a lot of group rotation. First, folks bought the financials, then they let them go down and moved on to the commodity stocks, then they moved away from commodity stocks and to technology stocks, and so forth.

I believe that is why the number of stocks making new highs is not keeping pace. If you keep leaving one group as soon as its run is over and moving on to a new one, then the number of stocks making new highs will falter.Sentiment Weighs In

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Therefore, we must look at sentiment. Back in mid-March I explained how dire sentiment was. We saw way too many bears almost everywhere we looked. At present, we don't see many bears, but we do see plenty of bulls.

However, with sentiment, we must pay attention to extremes, and in March, we had extreme bearishness. As yet we do not have extreme bullishness.

An extreme reading in bullishness would be if the Investors Intelligence survey showed at least 50% bulls, and it is more typical for highs in the market to be associated with a reading in the high 50s. The current reading is at 46%. I am guessing (although I have studied these numbers for several decades now) that we will see a marked jump in the percentage of bulls in the next few weeks.

Should we still have negative divergences in place when/if the percentage of bullish advisors reaches into the high 50% range, then the market will be vulnerable to a severe correction. Until then, it is only vulnerable to minor corrections.

Helene Meisler writes a daily technical analysis column and Top Stocks. For more information,

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. Meisler trained at several Wall Street firms, including Goldman Sachs and SG Cowen, and has worked with the equity trading department at Cargill. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. She appreciates your feedback;

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