Red Flags for the Rally in Stocks

Are stocks now overextended...?

THE FED-DRIVEN stock market rally continues in full force and is unabated, but I really question the rate of the advance and believe stocks remain overextended at this juncture, writes George Leong of Investment Contrarians.

The S&P 500 made another record high above 1,600 last Friday, but making that move to above the magical level came slowly and cautiously, which makes me feel somewhat uneasy.

The breakout—above the multiyear top near 1,565—is positive, as shown on the chart below, but the move was associated with light volume, which suggests a bearish divergence, based on my technical analysis.

Taking a look at the blue ovals on the stock market chart below, you will notice the possible pullback that has occurred after every six-month rally from November to April over the past three years from 2010 to 2012.

Whether we will see another retrenchment in the stock market this year is unknown, but based on the rate of the gains so far, I feel there is an above-average likelihood of this happening.

Featured below is a stock chart of the S&P 500 Index:

Chart courtesy of www.StockCharts.com

While the stock market continues to show upside potential, I think you should continue to ride the wave upward; however, you also need to be aware of the risk and the reality that the stock market could plummet on bad news, considering how high the gains have been so early in 2013.

Moreover, the Dow Jones Transportation Average is also offering up a red flag on the upward move in the Dow Jones Industrial Average.

The chart below shows that the industrials (as indicated by the green line in the top portion of the chart below) are moving higher, while the transports are showing a slight downward bias (as indicated in the bottom portion of the chart). Also, note the declining volume, which is a red flag of market disinterest.

Chart courtesy of www.StockCharts.com

The reality is that the decline in the transport sector means we could be seeing a drop-off in the transportation stocks. These are the companies that move the goods across the country and around the world. When these begin to decline, you have to question why the industrials are moving higher, since a decline in transports suggests businesses may be shipping less.

This is a key concept behind Dow theory, and it is critical in determining which way the market turns. The decline in the transports should make you nervous about the stock market, especially in terms of what lies on the horizon.

My advice at this juncture is to continue to ride the stock market upward, while also taking some profits off the table, especially on some of your major winners.