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TECHNICAL ANALYSIS 101 - PART 9

This is the ninth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Price Channels

Trending prices often form a channel where prices can be bounded above and below by parallel trendlines.  When trend channels form, it is helpful to draw the top and bottom trendlines and monitor how well prices stay within the channel. 

If prices in an uptrend fail to reach the upper channel line, the uptrend may be weakening and getting ready to reverse.  Also, if prices suddenly break above the upper channel line, the uptrend may be either beginning to exhaust itself and reverse direction or be starting a new, steeper trend.  Similar behavior also happens in downtrend price channels.

 

 

Trend Changes

Trending prices can only go three directions; continue in the direction of the trend, change to a trading range or reverse the direction of the trend.  Trend changes are most easily recognized by watching the price peaks and troughs.  An uptrend makes ever higher price peaks and troughs.  A downtrend makes ever lower price peaks and troughs.  And a trading range price peaks and troughs are roughly equal over time. 

A change in uptrend begins when a new price peak is similar or lower than the previous price peak.  The change is confirmed when the next price trough is similar or lower than the last price trough.

Changes in downtrends and price ranges occur the same way, new price peaks or troughs break the pattern of prior peaks and troughs with the next peak or trough confirming the change.

 

 

Price and Volume Data Adjustments

When a company declares a normal stock split, additional shares are created in a ratio to the current available shares. For a 2:1 (two-for-one) stock split, every pre-split share will be replaced with two shares.  Share prices are subsequently reduced by the split ratio (1/2 in this case) to maintain the total value (price multiplied by the total number of company shares) of the company.  In a reverse stock split, the total number of shares is reduced by some ratio, resulting in the stock price being raised by that ratio.

Price and volume data adjustments are necessary for technical indicators to be valid during the period of the stock split.  To accomplish these adjustments, pre-split prices are reduced by the split ratio and pre-split volume is increased by the split ratio.  The opposite adjustments are made for reverse stock splits.

Data adjustments are made in the same way for dividends and mutual fund distributions.

The following charts illustrate prices before and after a data adjustment for a stock split.  Notice how several strong “sell” signals on the first chart have disappeared on the adjusted chart. 

Next time, we'll look at how volume can confirm trend change signals.

BPNYA TURNS DOWN FROM OVERBOUGHT TERRITORY

I recently showed the NYSE Bullish Percent Index (BPNYA) having reached overbought territory over 70. the BPNYA is the percent of NYSE stocks that are in point & figure uptrends. I suggested that a drop below the May trough at 68 could signal a short-term top. Chart 1 shows that downturn has taken place as the breath indicator has fallen to 65% and formed a small "double top" in the process. Chart 2 shows the point & figure version of the same indicator. A three-box reversal into the down column also took place this week. That's another sign that the current uptrend is losing some breadth momentum. [Arthur Hill showed a similar downturn in the number of NYSE stocks trading over their 50-day moving averages]. Those are at least two reasons to be a little more cautious at current levels.

BREAKDOWN AND SNAPBACK

On Monday, in predictable fashion, prices broke down from the ascending wedge pattern we've been watching. Then, after a correction of 5%, prices began a snapback move up toward the recently violated support line (now overhead resistance). Prior to the breakdown, you will notice that overhead resistance was presented by the 200-EMA (exponential moving average), which also happens to coincide with the top of the wedge pattern. Once the snapback is completed, I am inclined to expect the correction to continue for a while. There is good support at 880, and after that the most obvious support is around 670.

As I mentioned last week, medium-term negative divergences are beginning to appear -- the PMO and fading volume on the chart below are two examples. Also, we are in the six-month period of negative seasonality, which will last through October. The mini-bull market has had quite a nice run, but, since we are still in a secular bear market, we should consider that perhaps prices are starting to roll over in order for the bear market to resume.

To change the subject, now seems like a good time to address the differences between the simple moving average (SMA) and the exponential moving average (EMA). A 200-SMA is the average of the last 200 days closing prices. To calculate today's 200-SMA, you drop the first price in the series (200 days ago), add today's closing price, then divide by 200. As you can see, the price 200 days ago has the same weight as today's close.

The EMA is weighted almost totally toward recent activity. To calculate a 200-EMA you begin with yesterday's EMA, subtract 1/200th of that number, and add 1/200th of today's closing price. (Math wonks will probably take issue, but it's close enough to help grasp the concept.) With the EMA we will not have a large move that happened 200 days ago affecting today's EMA.

The reason I am discussing this issue is to demonstrate how EMAs and SMAs can present completely different pictures. On the chart above, which uses EMAs, you can see how the 200-EMA appears to have stopped the forward progress of the S&P 500. There is also a substantial gap between the 50-EMA and the 200-EMA. (A 50/200-EMA upside crossover would generate a long-term buy signal.) On the chart below, which uses SMAs, the S&P 500 has broken above the 200-SMA, and the 50-SMA is about to break up through the 200-EMA (long-term buy signal).

Obviously, the SMAs present a positive picture versus an ongoing negative picture presented by EMAs, and such divergences are fairly common. So which one are you going to believe? I don't know how this will ultimately resolve, but I believe and will act upon the EMAs. I have always preferred EMAs because they do not give much weight to old numbers, but others prefer SMAs. In any case, you should use one or the other and stick with it.

 

Bottom Line: The ascending wedge formation resolved downward, and after a small decline, a reaction rally (snapback) has taken place. While downside resolution of this formation has only short-term implications, it is my opinion that medium-term correction has begun.

NOT MUCH TO LIKE ABOUT HOUSING...

As the "green shootists" shout from the rooftops about the bottoming of the US and world economy; we think a technical and the Housing Index ($HGX) in particular offer keen insight as to whether one component of what led the US into the housing & credit market bubble...will lead it out. We hear very little about the housing stocks these days, for many are trading at very low levels and many do not believe they will come back anytime soon. Moreover, the current technical patterns may bear this out...no pun intended.

Quite clearly, the downtrend in place since 2005 remains in place as the 50-week exponential moving average remains the bullish-bearish fulcrum point. However, one could reasonably make the argument that prices are attempting to bottom at the 50-level as it has provided support on the past two occasions for prices to visit this level. The first rally attempt off this level faltered in major previous low overhead resistance at the 80-100 zone, did so within the context of the 14-week stochastic turning lower through it trading moving average. This led to lower prices and a second test of the 50-level - which was successful. But, major overhead resistance proved its merit a second time as well, with the stochastic turning lower as well. Hence lower prices are to be anticipated once again, and the 50-level support level is as good as any to target.

For us to become more "bullish" of $HGX, we'd like to see prices hold above the 50-level and the stochastic to turn higher - this would cause us to "dip a toe" in the water with an initial "buy." But the real key to being bullish stands on a breakout above the previous high and the 50-wema...something we think unlikely in the months ahead. Therefore, since we are "bettin men", we'll simply believe prices will form a base between 50 and 100 over the course of the next or so. In other words, there isn't much to like about the housing market or the US economy...really.

Good luck and good trading,
Richard

GOLD SETTING UP FOR MOVE HIGHER

There are lots of questions in the market regarding possible inflation, deflation, and general market weakness.  One way to hedge against all three is to play gold.  Below is a long-term weekly chart that shows gold in a very bullish inverse head & shoulders continuation pattern.  The current pattern is preceded by an uptrend, a requirement for an inverse head & shoulder pattern to be effective.  While there are plenty of fundamental reasons to include gold in your portfolio, the technical reasons may be even stronger.

Check out the 5 year weekly chart on gold:

Watch for a breakout on gold above 1000, especially above 1025.  The argument for a move higher grows stronger if equities weaken further or simply consolidate this summer.  In my last article, I pointed out that the market appeared to be topping and I produced a video detailing the reasons.  If you haven't seen the video, or you simply want to check out other videos that have been produced, click here (www.investedcentral.com/public/department57.cfm).  There were several factors that influenced my call, including a VIX that had hit key long-term support.  I believed the VIX would bounce off support and, in doing so, would send the major indices lower.  Support at and around 28 on the VIX is quite strong as can be seen below:

The primary trend in equities remains bullish in my view.  I believe the current move lower is potentially establishing the right shoulder of a reverse head & shoulders bottoming pattern as shown below on the S&P 500 chart:

I'm expecting a test of the 50 day SMA, possibly slightly lower, before another leg higher.  So, short-term I expect the market to be choppy to lower.  I do, however, expect another rally to new highs in the not-too-distant future.  Any further move to the downside will have to be evaluated as to volume, divergences, etc. in order to determine if the move down is something other than a corrective decline.  An impulsive move to the downside would need to be respected.

Happy trading!

VIX BREAKS A TRENDLINE

A downtrend in the S&P 500 Volatility Index ($VIX) underpins the current rally in the S&P 500. After all, decreasing fear gives way to confidence. The chart below shows the VIX as a 3-day SMA to smooth out daily fluctuations. The VIX broke support on 12 March and this coincided with the March surge in the S&P 500. The VIX continued to trend lower as the S&P 500 extended its advance. While the S&P 500 hit a new high for the move in June, the VIX recorded a new reaction low to keep pace. With the sharp decline early this week, the VIX surged off its June low and broke the March trendline. This is a warning sign, but not quite enough to call for a new uptrend in the VIX. Look for further strength above the late May high signal a trend reversal and increase in fear that would be bearish for stocks.

AUTO-COMPLETE TICKER BOX

We've just added a new "auto-complete" dropdown box feature to our home page.  As you enter a ticker symbol or company name into the "Symbol" box, we now display suggestions from our symbol database for what we think you are looking for.  As you type more information, we'll make better and better suggestions.  It you see what you want, just click on it to see the chart.  Give it a try and let us know what you think.  We plan on adding this capability throughout our website over time.

TECHNICAL ANALYSIS 101 - PART 8

This is the eighth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Trend Psychology

The psychology of fear and greed of market participants ultimately determines the direction of prices in a market. Prices rise with greed (demand) and fall with fear (supply).  A price trend is simply a sustained directional price move.  It can be thought of as a “tilted” support/resistance zone.

A trend will continue as long as either fear or greed is in control of a market.  Trends fade or change direction as the balance of fear and greed changes.  The extent of fear and greed in a market can be seen by how quickly prices are trending down or up.

Trending

As stated earlier, a trend is a sustained directional price move.  Rising peaks and troughs constitute an uptrend; falling peaks and troughs constitute a downtrend.  A trading range is characterized by horizontal peaks and troughs.  Trends are generally classified into major (longer than six months), intermediate (one to six months), or minor (less than a month).  Long term are most interested with identifying long term trends where short term investors are more interested in minor and intermediate trends.  The following SharpChart shows examples of the different types and categories of trends.

 

Trendlines

A trendline is a straight line that connects two or more low or high price points and then extends into the future to act as a line of support or resistance.  The first two points establish the trend line while additional points validate it.

 

The following SharpChart is a real example of how an uptrend line is drawn with a trend change.

 

An uptrend line has a positive slope and is formed by connecting two or more low points. Uptrend lines act as support.  As long as prices remain above the trend line, the uptrend is considered intact.  A break below the uptrend line indicates that demand has weakened and a change in trend could be imminent.

 

A downtrend line has a negative slope and is formed by connecting two or more high points. Downtrend lines act as resistance.   As long as prices remain below the downtrend line, the downtrend is intact.  A break above the downtrend line indicates that supply is decreasing and that a change of trend could be imminent.

Next time we'll look at Trend Channels and Trend Changes.

TIME TO TURN CAUTIOUS

I've been bullish for several weeks now, but the tide is changing.  We are running out of historical bullish periods until later in 2009.  We have a few periods that are a bit more optimistic, but by and large the stock market remains either neutral or bearish through the remainder of the summer from a historical standpoint.  I've discussed previously the tendency for the stock market to perform well early in May, then again late in May.  The same generally holds true for June, as historical bullishness falls mostly in the early and latter parts of the month.

It's not just seasonality that has me cautious though.  There have been an increasing number of bearish signals forming in the market over the past few weeks and I've communicated those one by one to our members.  Volume trends have generally remained strong across all of the major indices and that's helped keep a bid under the market.  But mixed signals have slowed down the number of alerts we've been willing to play.  The keys to successful trading in the stock market begins with determining the highest probability of market direction.  During periods of mixed signals and consolidation, risk should be minimized via fewer trades or smaller positions.  Many traders struggle simply because they don't adapt their trading strategy to the market at hand.

Technical analysis provides the clues necessary to navigate the market.  Sectors that outperform the S&P 500 should produce the majority of individual stocks traded.  Too many times stocks are bought without regard to their industry and technical analysis.  Instead, traders chase stocks, buying after a significant move has already been made.  The absolute best time to buy a stock - in my opinion - is after it's pulled back in an uptrend to key support.  In an uptrending market with solid divergences, the 20 day EMA test is normally a great place to enter.  That was the focus of our trading during late March, throughout April, and into early May.  When divergences turn negative, however, it's best to avoid stocks until they at least reach their respective 50 day SMA.

Let's take a look at the Russell 2000 index, a barometer of small cap stocks.  These stocks tend to perform poorly in June, outside of the first few days and the last few days of the month.

 

As you can see, the divergences are weak and key resistance areas are upon us.  While the market may surprise me and continue rolling here, I suspect we're at or near a fairly significant short-term top.  In fact, I'm concerned about the overall market.  I've spoken for the last several weeks about the underlying bullish technicals.  I'm seeing a lot more warning signs now.  If interested, click here for a video presentation that details the various warning signs.

Happy trading! 

DRUGS & HEALTHCARE POISED TO OUTPERFORM

As the current rally perpetuates beyond what reasonable technicians would have thought at this point - the buying surge has now surpassed 57 trading sessions, it would appear traders are searching rather intently for those "laggard" groups or stocks to provide them with enhanced risk-reward benefits. This is certainly reasonable we think for the theory is that they will eventually play "catch up" with the broader market as gains in other "high beta" groups are wrung out. To this end, we believe that the Pharmaceutical-Healthcare-Biotechnology groups offer just such a "catch-up" potential.

Our focus today is upon the AMEX Pharmaceutical Index/S&P 500 Ratio ($DRG/$SPX).Clearly $DRG has broken out against $SPX given the declining trendline breakout, with the ratio subsequently correcting lower in a reasonable fashion to "kiss" the breakout level. Thus far, this "kiss" has been successful, with the 20-week stochastic now at oversold levels - a circumstance that in the past with an increased probability of a rally developing. This time should prove no different, and if we had to forecast...we would believe that the highs near .33 would be taken out on any rally.

If we had to postulate two rather interesting individual stocks to be long, then we would look towards Abbott Labs (ABT); Sepracor (SEPR) and Cephalon (CEPH).

Good luck and good trading,
Richard

200-DAY AVERAGE IS STILL DROPPING

Virtually all major market indexes (including the Dow) have now exceeded their 200-day moving averages. That's a positive sign for the stock market, and adds more weight to the view that a major bottom has been seen. As I wrote a couple of weeks ago, however, the "direction" of the moving average line itself is also important. Legitimate bull markets usually require that the 200-day average also turn higher. For that to happen, stock indexes have to first clear the 200-day line (which they've done). Then, stock indexes have to reach the price level formed 200 days ago. In other words, the latest closing price has to exceed a closing price 200-day days ago. The solid line on top of the chart below shows the 200-day "price channel" currently at 1303. It's doubtful that prices will reach that level in the near future. The S&P has yet to even clear the middle (dotted line) which currently sits at 985. [The dotted line sits midway between the upper and lower channels and often acts as resistance in a downtrend]. As good as the spring rally has been (with most indexes having also cleared their January highs), I believe that the market is still in need of some corrective action (or consolidation) before moving substantially higher. V bottoms are extremely rare. W bottoms are a lot more common. So are head and shoulder bottoms. It seems unlikely that the market will continue to rally in a straight line. More basing activity is most likely needed. And that's going to require more time.

IMPORTANT RESISTANCE ENCOUNTERED

On the chart below we could attach a callout window to the rally that began in March and entitle it "Bull Market Rules Apply". Bull market rules generally mean that bullish setups will almost always resolve positively, and that bearish setups will usually fail to execute, because the market is being driven by a strong bullish bias. For example, at the early-May price top we had a perfect setup for a price reversal that could have declined into a nice correction. Many medium-term indicators were very overbought, and that condition needed to be cleared.

However, instead of correcting downward, prices moved sideways in a consolidation pattern, clearing the overbought condition without giving up any significant ground. Then at the end of the consolidation a strong breakout occurred. This breakout could have been a blowoff top, but, instead of immediately reversing downward, prices began to consolidate (so far for four days), erasing any hope the bears may have had for a decline.

Now, as you can see, prices have hit resistance at the 200-EMA. Not only that, but there is a long-term declining tops line just ahead. This resistance is strong and significant, and a reasonable assumption is that prices will be turned back from it.

On the weekly-based S&P 500 chart below, the declining tops line is displayed in its entirety, and its significance is more easily grasped.

So what's next? If the underlying bullish market bias persists, then the resistance will be overcome; however, the rally has gone long and far enough that it could be time for it to end. I think it is too late to open new longs, and too early to go short. We have been on a buy signal since March 17 and are sitting on a nice gain, so we can comfortably sit tight and wait to see what happens.

Bottom Line: We have experienced a nice rally from the March lows, but the price index has encountered important, and presumably strong, resistance. The chart evidence make a compelling argument that the rally is finally over, but the market's positive behavior to date warns against getting too bearish too soon.

OVERBOUGHT AND BULLISH

Even thought the Dow Diamonds (DIA) is overbought medium-term, the recent breakout is short-term bullish and this breakout is holding. On the daily chart, DIA broke above flag resistance with a surge on Monday. This move pushed CCI above 100 to turn momentum overbought. Even so, I would consider the trend both overbought and strong as long as CCI holds above 100. Notice how CCI bounced off the zero area in late May. Medium-term momentum should be considered bullish as long as CCI stays positive.





The second chart shows 60-minute candlesticks to focus on the recent breakout. This chart features a consolidation, a breakout and a support zone (yellow area). A key tenet of technical analysis is that broken resistance turns into support. In other words, a strong breakout should hold. Failure to hold this breakout and a move below the yellow support zone would be short-term bearish. As such, this is the first support area to watch for signs of a trend change.