A month ago, I outlined a bullish picture for stocks but said I'd be on the lookout for warning signs. Well, now they're starting to appear.
The first problem is that earnings forecasts have showed a marked weakening. While this was largely expected, it's hard to say how much of it was priced into the market. It's a little bit like a beloved relative passing away: Just because you know it's coming doesn't make the bad news any less painful.
We all knew technology would be weak, but the selling in big industrials such as General Electric, 3M, and Tyco is what's really caught my attention. Today's price action in Boeing was equally worrisome for the bulls because it opened higher by almost 3 percent but closed lower. It also looks as if the aerospace giant is rolling over at its 200-day moving average, which is never a good sign.
The second problem is that the S&P 500 has now slipped below its 50-day moving average for the first time since June. It initially bounced there on Oct. 15 but failed to hold it Monday and has now closed below it for the last two sessions.
The third problem is that the rally in the homebuilders appears to be running out of steam. These have been the strongest major industry group on researchLAB over the last 12 months. But the charts of companies such as Lennar and Toll Brothers show falling MACD indicators at the same time prices have climbed. That's called bearish divergence, and it often precedes a pullback.
Some of these, especially LEN and TOL, have returned to long-term levels that could become resistance.
Another concern is that the Fed repeated the usual mantra of quantitative easing in its policy statement on Wednesday, yet investors sold the news. Have we all built up a tolerance to Ben Bernanke's punchbowl?
The last problem is my own bullishness. Readers know I have been very positive on stocks for a while, and I accurately anticipated the third-quarter rally when most other commentators spewed nothing but gloom and doom. Unfortunately being right has a nasty tendency to make people complacent and blind to warning signs that might go against their expectations. I very well might be guilty on this front.
Of course, I can still rattle off reasons to like stocks, but I won't even mention them. After all, they will be even more true after the market goes lower.
The next two sessions could determine direction for a while because we get initial jobless claims and durable goods tomorrow, while Friday brings GDP and consumer sentiment. I suspect they will be positive. The question is: Will the market care? I'll be watching how the market reacts when the news comes out.
If we do head lower, it's good to have a shopping list of short candidates so you can profit from the bloodletting. Here are some that make sense to me:
Bank of America (BAC): Yes, it's been a great trade from the long side, but it's been stalled around $9.30 for more than a month and could easily head back toward $8.
Azz (AZZ): This is one of my favorite little industrials, and it's been on an incredible run for the last year with one great earnings report after another. But it failed to hold a bullish gap after the most recent set of numbers. MACD has also been falling since July. If people start anticipating a weaker economy, AZZ could take a beating.
Honeywell (HON): This blue-chip is parked at long-term resistance around $61, a level that goes back more than a decade. Puts are very cheap in this name, and weakness in the broader market could easily send it down to $57.50 or even $55.
On the long side, health insurers like UnitedHealth (UNH) and Aetna (AET) could be immune to a weak economy and have recently seen lots of bullish call buying.
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Oct. 24.)
