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Relax, the U.S. equity rally isn’t going anywhere

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The U.S. market has entered choppy waters and with the Dow making new highs, some investors are concerned that equities are about to roll over and head lower. Technical analysis, however, suggests that the rally is still intact and merely pausing to correct early-year frothy conditions.

Bank of America Chief Investment Strategist Michael Hartnett has been bullish on equities since mid-2012 and a staunch advocate of the Great Rotation theory – that investor assets will continue to migrate from fixed income to equities and push the major stock indices higher. In assessing short term risks, he writes:

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"Our Bull & Bear Index remains in "extreme" bullish territory which suggests a pullback is desirable. Watch the U.S. investment broker index (XBD), the housing index (HGX) … to gauge correction risks… most of the global equity long positions are tied to the recovery in U.S. real estate and consumption, according to our most recent Fund Managers Survey."

With the homebuilders and financials driving the rally, technical analysis of these two sectors provides a window into its sustainability. The first chart maps out the performance of the NYSE Broker Dealer Index by RSI - Relative Strength Index. (Reminder: an RSI below 30 indicates oversold conditions, above 70 suggests overbought). The pattern on the upside is textbook – the index falls shortly after climbing above 70. In 2013, RSI showed the sector significantly over-extended by Valentine's Day, and it has now receded to the middle of the overbought/oversold range.

The technical picture for the Philadelphia Stock Exchange Housing Index is remarkably similar. After a powerful rally that began in late 2011, the index took a breather between February and June 2012 before resuming its path higher. The Homebuilder benchmark appears to be building another base after RSI reached overbought levels in mid-January 2013. We'll be happier if the index retakes previous highs at the 191 level but overall, this is the picture of a healthy market correction from over-exuberant levels.

Neither the homebuilder or investment bank indices are showing pronounced technical weakness. That's a positive sign for market action in the coming weeks. Judging by RSI, investors just got slightly ahead of themselves and things have now returned to normal in the main sectors driving U.S. equity markets higher.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.

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