Why Investors Must Be Cautious at These Prices

NEW YORK (TheGoldAndOilGuy.com) -- On Oct. 8 the financial market experienced a broad-based selloff. Every sector was down, with utilities being the only exception.

The individual leadership stocks, which are typically small to mid-cap companies -- as seen by the iShares Russell 2000 Index ( IWM) exchange-traded fund -- that have a strong history and outlook of earnings growth were hit hard as well.

Whenever the broad market experiences a price correction, one of the most important factors I analyze is how well leading stocks hold up and show relative strength to the broad market.

So, where does this leave us?

When stocks that have been leading the market higher and only pausing during market corrections in the S&P 500, Dow and Nasdaq, it's a positive sign. This tells us investors and big money continues to flow into the risk-on assets like stocks.

Conversely, when these leading stocks/sectors begin succumbing to the selling pressure of the broad market, it quickly grabs my attention and tells us it's time to be aware that a major top may be forming.

It looks as though the broad market rally is just barely hanging on. If the leading stocks and sectors begin breaking below their 50-day moving averages, my proprietary S&P 500 Market Timing & Trading System will shift to sell mode and things could get ugly for those who do not know how to trade a bear market.

Weekly Relative Strength Showing Negative Divergence

This chart has two important things I would like to point out. First is the fact that the RSI has being overbought twice in the past three years, with the most recent one taking place a few months ago. The last time this took place the S&P 500 had a very strong correction.

The second insight the RSI is providing is the diverging price and relative strength as shown with the purple lines on the chart below. This is telling us that the power/momentum behind the market is slowing.

Courtesy of StockCharts.com

Daily Bullish Percent Index Shows Negative Divergence

I always prefer to watch and analyze the NYSE as it's the "Big Board" where all the huge money is flowing from traders and investors. The chart below clearly shows that fewer stocks are moving higher, as seen with the purple bullish percent index line. With fewer stocks making new highs and the stock market continuing to climb, this is a warning sign that this bull market is slowly running out of steam.

Courtesy of StockCharts.com

How Long Can Technology and Financials Rise?

Two very powerful sectors are holding up well, but once they start to break down from these chart patterns things could get ugly real quick.

The technology sector, as seen by the Technology SPDR ETF ( XLK), looks to be forming a bearish rising wedge. If/once it starts to slide it will have a strong impact on the broad market.

Courtesy of StockCharts.com

As for the financial sector, as seen in the Select Sector Financial Slct Str SPDR Fd ( XLF), the recent price action of scattered trading ranges looks to be similar to the top we saw in 2011. If this is the case, then we have bearish head and shoulders pattern with a rising neckline forming. Once price breaks through the neck line, we should expect sharp drop in price.

This sector is heavily weighted in the S&P 500 so if it starts to drop, expect the S&P 500 to fall with it.

Courtesy of StockCharts.com

Major Market Top Lurking

The chart below pointing out the next bear market likely to take place is a scary-looking chart to most individuals. But if you know what you are doing, it can provide more profits in a shorter period of time than a four-year bull market.

If this market is starting to stall out and is in the process of forming a top, keep in mind that market tops are a process. They take typically three to six months to form before a true breakdown occurs and the bear market starts. Until then, price will be choppy and difficult to trade.

Courtesy of StockCharts.com

Cautious Trading Conclusion:

In short, this report shows you some major divergences in the financial market. Remember, you do not really trade off divergences as they are not good at timing. They are simply a warning sign telling us something large is brewing and that risk is higher than normal.

There are few ETFs I like on various sectors and commodities that show some oversized upside potential in the coming weeks/months. What takes place in Washington this week will move the market and likely trigger some sharp moves. Until then, sitting tight is the safe play.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Chris Vermeulen is founder of the popular trading sites www.thegoldandoilguy.com and www.ActiveTradingPartners.com. There he shares his highly successful, low-risk trading method. Since 2001, Chris has been a leader in teaching others to skillfully trade in gold, silver, oil and stocks in both bull and bear markets.

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