The end of the stock rally?

Since stocks bottomed on November 2, the S&P 500 has gone on to gain 6%. But there are troubles beneath the surface. Volume and breadth trends remain lackluster. Volatility is creeping higher. Entire segments of the market are lagging the advance.

These are all signs that we could be looking at another end-of-month correction similar to the ones seen in late August, September, and October. All of these declines took stocks down to their short-term moving average. The last one was the most severe, resulting in a decline of 6.5% for the S&P 500.

In fact, my research suggests a deeper decline in line with the drop earlier this summer could be ahead. Sound crazy? Japanese stocks have already tumbled beneath their October lows. And we've yet to see a painful yet healthy correction among the largest blue-chip stocks that would clear out speculative excess. Here's why.

I've been focusing on the decline in trading volume lately because traditionally, November is one of the busiest and best performing months for stocks as end-of-year optimism mixes with a desire to place trades before volume dries up around the holidays.

I crunched some historical data to show you how this works. Between 1929 and 2008, November's trading represented 8.9% of the entire year's action in the Dow Jones Industrial Average. This was second only to December's 9.1% share. October and January tied for third at 8.7% of total annual volume. Based on this research, the 35% drop in volume so far this month is an anomaly.

What about breadth? Illustrated in the chart above, the NYSE Advance-Decline line is forming a negative divergence with the NYSE Composite Index. This isn't some unfathomable technical mumbo-jumbo. Quite simply, what this means is that as stocks power to new highs, fewer stocks are participating in the movement. The last time there was a similar non-confirmation of an upward movement was during the summer of 2007 -- just before stocks hit their all-time high and descended into the bear market.

While I'm not suggesting a slump of that magnitude is ahead of us, this technical indicator is a big yellow flag.

And for yet another perspective on the problem, veteran fund manager Jack Ablin from Harris Bank flagged the recent decline in what he calls the "Smart Money" index. It's based on the notion that retail investors dominate the first 30 minutes of trading while professionals dominate the last 30 minutes. To calculate it, he subtracts the S&P 500's move in the morning from its movement in the closing minutes of trading.

Based on this measure, he says, professionals have checked out: Since October, the Smart Money Index is up 1.5%, vs. the 7.2% rise in the S&P 500. This suggests that November's narrow, light-volume rally may have been fueled more by late-coming retail investors than by pros.

Also, the relationship between the supply and demand for stocks since the low on November 2 has yet to improve. According to the measures compiled by Lowry Research, the current rally has been driven much more by a reduction in supply than by an increase in demand. The rally out of the low on October 1 was similarly troubled while the September rally was much more balanced.

This could be an indication that prices didn't dip low enough over the past two months to really excite new buyers. We could be on the verge of that dip now.

And finally, new research from Citigroup's chief equity strategist Tobias Levkovich that shows that expectations for the future might have moved too far lately. When the percentage of companies receiving upward earnings estimate revisions from analysts is high (blue line), as it is now, the market tends to flatten out as reality sets in (red line).

The last time this happened was in early 2004, as you can see in the chart above, just ahead of a nine-month stall. The more dramatic example was in 2000 just ahead of the implosion of the dot-com bubble.

My positions

My portfolio at Wall Street Survivor remains heavily short. For the month, I'm up 24.6% versus a 6.8% rise in the S&P 500. My best position is the Direxion 3x Emerging Market Bear ETF (EDZ), which trading with a cumulative gain of 8.2%. I lost some fur when I set my positions a few days too early and was caught on the wrong side of the big move higher on Monday. But now that the move lower has started, I expect the decline to last through the begining of December.

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.