Of all the indicators you can choose from to assess the current market conditions, one in particular stands out – and it is sending a clear warning. It’s a warning that it has flashed before, and was followed by a big drop in the market.
It’s my Composite Liquidity Indicator (CLI).
The CLI is telling us that the market is as overextended now as it was in January, just before the big February “adjustment.”
That correction looked like the beginning of a bear market.
Since then, the market has crawled all the way back.
On Wednesday, and again today, the S&P 500 has momentarily exceeded its January high by a few pennies.
But the CLI is now telling us that market risk is as great, or greater, now than it was in January.
As you can see, the market is now severely overvalued.
Stock prices inflated by an astonishing 24.9% over the 12 months ended January 17, leading to an all-time record overbought reading on the CLI.
We therefore knew then that the market was in an extreme buying panic – a mania – from September through most of January.
The market broke in early February, apparently ending the mania.
I thought then that that decline initiated a major bear market. Since then the market has had 4 rallies.
The mania has returned in the current rally. It has taken the market all the way back to the January high, matching the degree to which the market was then extended vs. liquidity.
As I showed you earlier this week, this rally has been driven by borrowing. That increase in leverage only increases the danger. It increases the risk of a disorderly adjustment, otherwise known as a “crash.”
While there is less liquidity around in total, dealers, investors, and traders have expressed a preference for stocks, pulling cash from other investment classes, including cashing out short term paper, but largely with the use of margin debt.
Eventually this will lead to a hard stock market break. Only the timing is in question.
That’s a matter for technical analysis, which I cover in depth in the weekly Wall Street Examiner Pro Trader Market Updates. I report the highlights to you from time to time here in brief in these Sure Money reports.
An extension of this rally is obviously possible – but over time, the pull of a diminishing amount of money in the system will result in a breakdown in stocks into a trend of lower highs and lows as long as the Fed continues to conduct its bloodletting operations.
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When the market finally starts down I would expect it to correct at least to the 39 week moving average of the CLI, which is now near 2450 on the combined chart of the CLI and SPX.
I expect a bear market to develop, and ultimately for the CLI to show where a bottom on the SPX has been reached.
Meanwhile, the SPX has rallied through my “line in the sand” at 2850.
I had recommended in past posts that if that happened, we could participate in a rally with limited risk by buying SPY calls using the income from our cash holdings.
I recommended buying at or near the money calls with about a month to expiration.
I would continue to keep most of our assets in cash to protect against what I believe is coming.
Since clearing 2850 last Friday, the market rallied a bit, but then pulled back. That showed that there’s technical resistance at the level of the January high around 2873-74, give or take a few points. Overshoots are common at resistance. We need to beware of that.
The market could make a double top there. But if the market breaks out through that, the calls will take care of helping us reap some gains, while we sit safely mostly in cash.
If the market stalls here, I will look for a signal to reverse that trade to buy puts for the big decline to come.
So stay tuned right here in the days ahead for updates.