StockCharts Blogs - ChartWatchers

As Risks Rise, Discipline and Stock Selection are Critical

In a perfect world, we'd all invest every dime in winning stocks each and every trading day.  Unfortunately, I haven't seen that kind of trading world yet.  So as we approach each day, we must assess the risks in the market and determine an appropriate trading strategy.  At times, it makes good sense to go "all in".  But most of the time, the nature and size of our trades should be based on the risks inherent in the market.  I've discussed some caution of late and I maintain it.  It doesn't mean the market cannot go higher and that you cannot trade on the long side.  It simply means you should do so much more selectively and with stops in place.

The good news is that price/volume trends remain very strong and this indicator is the most important of all, bar none.  There's a laundry list of negatives that we must respect though.  The MACD has been negative on the daily chart across all of our major indices for the last 3-4 weeks.  There's also a negative divergence on the 60 minute charts, as the NASDAQ chart below shows:

 

Stochastics and RSI are both near-term overbought across our indices as well.  They could use a pullback to help consolidate recent gains.  Without a pullback, the overbought conditions last longer and generally encourage a steeper selloff when one finally occurs.  I'd prefer to see a little unwinding of these oscillators now rather than later.  Historically, we've entered the third worst period of the year on the S&P 500.  Only one week periods in October and July have produced worse results historically than the period we're in.  So far, this period is holding up well, but we have another week or so to negotiate before we can call it a success.

Finally, and perhaps most importantly, the masses are jumping into equity options on the call side.  This is a MAJOR warning sign to me as retail traders, unfortunately, rarely walk away with the pot of gold.  The Friday that options expire usually carries very heavy volume on both the equity call and equity put side.  I tend to follow the equity call and put activity on days other than option expiration Fridays.  In early May, I saw record levels of equity calls traded.  In fact, May 7th (this day marked the top for awhile) held the record for most equity calls traded on a non-option expiration Friday.  When longs start to believe the market cannot go lower, it does.  The May 7th record of equity calls traded was broken this past Wednesday, September 16th, then challenged again on Thursday.  I'm seeing way too much complacency in the market.  I've seen many in the media saying that no one believes the market can go higher, therefore it will.  While that's nice to say, I simply can't find proof of that by looking at options.  I'm seeing the exact opposite - equity option traders don't believe the market can go DOWN.  That ALWAYS makes me nervous.

Can the market go higher from here?  Absolutely, and without a trace of pullback too.  Overbought can stay overbought.  There are NO guarantees in the market.  Would I be "all in" expecting that continued bullish behavior?  Absolutely NOT.  The risks are too high.  I believe you have to be very, very selective in trading the market at this level.  While shorting has been a practice in futility for several months, the money has been made on the long side during this stretch.  I continue to look for the stocks with the very best volume trends, suggesting accumulation.  The best time to enter those stocks is either just as they make a new breakout on confirming volume OR on a pullback to retest a previous breakout level or a major moving average.  Personally, I prefer the latter as risks are better and more easily controlled.  One feature that we've added at Invested Central over the past 6-7 weeks is a Chart of the Day.  These charts are designed to be highly educational and they focus on finding candidates that possess many of the reward to risk characteristics that I look for.  You can check these charts out daily at CLICK HERE.

During our national radio broadcast, we discuss the Chart of the Day as well at 8:42am EST.  CLICK HERE to follow us LIVE on the air each and every trading day from 8:00am-10:00am Monday thru Friday.

Happy trading!

LOWER PRICES AHEAD FOR XLY?

The insatiable need to own stocks has manifested itself in most S&P sectors, in which the Consumer Discretionary sector is doing far better than anyone can believe. Most, if not all of the clients we speak with on a daily basis do not understand why this is so; they note that they and and their friends and neighbors have pulled back, as well as deleveraging is the order of the day. Therefore, why then, have we seen 75% move off the low in the Consumer Discretionary ETF (XLY)? Quite simply...liquidity.

But having said this, we think the liquidity is going to slowly, but surely dry up as the animal spirits of the "chase" for XLY come to an end. Traders and investors alike will look around them and ask why XLY is so high, and how did it get there? For us, we find the technicals behind a potential short-trade rather "good" at this point, for prices have rallied back to major overhead resistance at the 50% retracement levels off the lows. Too, prices into 120-week moving average resistance with the 30-week stochastic at overbought levels. This seems to us to be a low risk/high reward setup, but it is really only a matter of short-term timing in which to be short XLY. In our opinion then, lower prices are ahead; with our target a simple 50% retracement of the rally back towards the $22 level.

FALLING DOLLAR FAVORS FOREIGN STOCKS

Arthur Hill reviewed some standard intermarket relationships on Thursday. One of the best known is the inverse relationship between the U.S. Dollar and commodity prices. That's why a falling dollar has had a bullish impact on commodity prices since the spring. The falling dollar has also boosted global stocks as money moved out of that safe-haven currency into riskier assets like stocks. But not all stocks rise equally at such times. A falling dollar has a much more bullish impact on foreign stocks. Since the March top in the dollar, for example, the S&P 500 has risen 56%. Foreign stocks, however, gained 72%. The stronger foreign performance was due largely to the falling dollar. The red line in the chart below is a ratio of the Morgan Stanley World Index (Ex USA) and the S&P 500. The green line is the U.S. Dollar Index. The inverse relationship between the two lines is very clear. Foreign stocks did much better than the U.S. from 2002 to the end of 2007 while the dollar was falling. Foreign stocks did much worse than the U.S. during the second half of 2008 as the dollar rallied. The dollar peaked in March of this year and has been falling since then. The rising ratio shows foreign stocks outpacing the U.S. since the dollar top in March. A weaker dollar favors heavier exposure in foreign stocks. The direction of the dollar also determines when it's better to use foreign ETFs.

TRIALS AND TRIBULATIONS

Hello Fellow ChartWatchers,

We're taking a break from our on-going Technical Analysis 101 series to give you an update on the two disruptions that happened last week.  I want to make sure everyone understands what happened and what we are doing to prevent it from happening again.

In case you missed it, on Wednesday, September 9th, our main connection to the Internet was cut.  Around 4:45pm Eastern, "some guys" working in a manhole cover outside our offices damaged our fiber cable which knocked us off the air.  (I actually spotted those workers as soon as the problem occurred and I went over as asked them if they had touched our cable.  Unfortunately, they lied to me and said that they didn't.)  Compounding things, the true nature of the problem wasn't obvious for several hours and we had to try and eliminate several alternate theories before we discovered that the cable had in fact been damaged.

After nine hours of testing various theories, we gave up on the fiber cable and moved our site back onto the four T3 connections that - luckily - we still had available.  As a result of the nine-hour outage, we gave existing members a free week of additional service.

The following Monday, our index data vendor ThomsonReuters stopped providing us with data for the S&P 500 index along with about 10 other important CBOE-based indexes.  The problem was traced down quickly, but Thomson did not re-enable that data for us until after the market closed.

Both of these issues are completely unacceptable.  Here's what we are doing to prevent them in the future.

1.) The Gigabit Fiber connection has been fixed.  We hope to move our Internet traffic back onto that larger, faster connection Monday evening.

2.) We have ordered a second Gigabit Fiber connection that uses a different physical path so that if one connection gets damaged, the other will continue to work.

3.) We are installing additional physical protection devices for our cables down in the conduits next to our building.  We are also trying to track down "those guys" who caused the problem and recover some of our costs.

4.) We have purchased a second router and fiber-optic interfaces to act as backups for our primary equipment.

5.) We are moving our primary data source for CBOE index data from ThomasReuters to IDC/Comstock this week.  We are also expediting our entire move off ThomsonReuters as a primary data provider although that process will still take time.

6.) We have sent letters of protest to ThomsonReuters and CBOE about their vague and contradictory communication policies.  Unfortunately, we don't have much leverage with those huge companies - which is part of the core problem.

When we do have disruptive problems like this, we will try to communicate as much information about them to you as we can via our Status Blog.  Make sure to check that blog whenever you experience a problem accessing our charts.

Breadth Remains Bullish

With a surge over the last two weeks, the AD Line and AD Volume Line for the NYSE hit new reaction highs. The first chart shows the NYSE AD Line moving above its August highs with a sharp advance this month. The AD Line is a cumulative measure of Net Advances (advances less declines). This indicator rises when there are more advancing stocks and falls when there are more declining stocks. It is one of the simplest, and purest, breadth indicators. With a new high this month, there is no sign of weakness right now. If anything, the AD Line looks overextended and ripe for a rest.

Click this chart for details.

The second chart shows the NYSE AD Volume Line, which is a cumulative measure of Net Advancing Volume (volume of advancing stocks less volume of declining stocks). While the AD Line and Net Advances reflect small and mid-cap performance, the AD Volume Line and Net Advancing Volume reflect large-cap performance. For the AD Line, an advance counts as +1 and a decline counts a -1, regardless of market capitalization or volume. This puts small-caps on equal footing with large-caps. Volume is a different story because large-caps dominate the most active list. With the AD Volume Line also moving to a new high for the move, breadth for large-caps is also strong and shows no signs of weakness right now.Click this chart for details.

BULL MARKET RULES STILL APPLY

For weeks we have been looking for a correction, and a time or two we experienced some trepidation that the bull market might be over, but all the market has done is produce a series of minor pullbacks. At the present it is trying to break out of a rising wedge formation, the opposite of what we normally expect with a bearish formation. This kind of behavior continues to supply us with evidence that bull market rules still apply. That means that we should continue to expect bullish resolutions rather than bearish ones.

Market internals have continued to remain overbought. For example, the PMO (Price Momentum Oscillator) on the above chart is near the top of its normal range. On the chart below we see three indicators representing the ultra-short-, short- and medium-term time frames. You can see how they have all reached overbought levels and topped. In a neutral or negative market, this would present a great sell signal, but you can also see how twice before these conditions failed to produce any serious decline. Perhaps the third time is charmed?

Bottom Line: Many market indicators are overbought and topping, presenting us with yet another setup for a correction, but bull market rules say we shouldn't count on it. A small pullback is more likely. To be sure, our bullish assumptions will ultimately prove wrong when the final top of this rally arrives, but our trend following models keep us from pulling the trigger prematurely. We remain on a 3/17/2009 medium-term buy signal for the S&P 500.

GOLD AND SILVER HAVE BIG WEEK

GOLD TESTING ALL-TIME HIGH... Last Friday I wrote about the bullish potential in gold and gold shares. That optimism was based on two bullish chart patterns which are shown below. The first is the bullish symmetrical triangle shown in Chart 1 for the Gold Trust ETF (GLD). This week's upside break of the upper resistance line (on heavy volume) is bullish and signals a test of its February high near 100 (which corresponds to $1,000 in bullion). Chart 2 shows why that's an important resistance level of its own. Chart 2 (based on the price of bullion) shows an inverse (or continuation) head and shoulders pattern with a neckline drawn over gold's 2008-2009 highs. A close through that level (which appears likely) would be even more bullish for gold and gold shares. In fact, gold shares have risen even more than bullion this past week. So did silver.

TECHNICAL ANALYSIS 101 - PART 12

This is the next 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.)

Volume Confirmation of Price Patterns

When identifying potential price patterns on a chart, it is crucial to try and verify that the market psychology behind the price pattern is really happening at that point on the chart.  One of the best ways to do that is to use volume to confirm things.

In the case of a rectangle pattern, volume should be decreasing while the rectangle is forming.  There may be volume spikes whenever prices get near the top or bottom of the pattern, but in general, as a rectangle pattern continues to develop, volume should decrease.  Volume will probably spike up heavily immediately after the breakout as people realize that the support or resistance line has been broken.

Triangle patterns should have a similar volume pattern - decreasing volume while the triangle is forming with a sharp increase in volume once a breakout is achieved.

Again, the diagrams above are idealized - the real-world is much messier.   Consider this example:

Notice that ARST didn't have a smooth decrease in volume but instead had several "mini-spikes" that corresponded to each change in direction of the "coil."  The key however is that each mini-spike was smaller than the previous one (with the exception of July 21st, but that was early in the coil's formation).  Once that downward volume trend was well established, a big spike above that trendline would signal the breakout - just like on September 1st.

Consolidation / Continuation Patterns vs. Reversal Patterns

So far, the two price patterns we've looked at - Rectangles and Triangles - are examples of "Consolidation Patterns" also known as "Continuation Patterns."  They are called that because, in general, after the pattern completes prices will usually continue whatever trend they were in prior to the pattern forming.  In order words, if prices were in an uptrend prior to a rectangle pattern forming, prices will usually resume the uptrend once the rectangle pattern finishes.  Basically, consolidation patterns are places where the bulls and the bears have another short-term "argument" about the stock, but it is a half-hearted one.  The "bigger picture" situation doesn't really change.

Next, we are going to start looking at "Reversal Patterns."  These are where the fireworks occur.  If consolidation patterns are skirmishes, reversal patterns are the big battles.  When reversal patterns start to appear, the current trend is in real danger and lots of people start to pay attention.

Next time, we'll look at the granddaddy of all reversal patterns - the Head and Shoulders reversal.

ON HIATUS THIS WEEK

Richard will return for our next issue.

CHINA MAY HOLD SOME CLUES

China's Shanghai Composite index is swinging wildly in both directions, reminiscent of the 1999-2002 moves by the NASDAQ.  From a long-term perspective, you can clearly see that trends in both directions have been exaggerated.  Any time that we've seen impulsive moves in one direction or the other, we have seen follow through in that same direction.  From the mid-2005 to mid-2007, the impulsive moves were up while the corrective moves were down.  From the peak in 2007, just the opposite occurred with impulsive moves lower.  Take a look at the chart below and study the monthly swings in this index from mid-2005 up until now:

It's impossible to ignore that impulsive move down last month.  Thus far in September, the Shanghai is rebounding.  Will it last?  Well, some of the short-term strength was suggested by the MACD histogram on the daily chart, which printed a positive divergence on the latest move lower in China.  The chart below is a three year chart and it shows the positive divergence on the MACD histogram and a triangle formation to keep an eye on:

The MACD histogram measures the distance between the MACD (thick black line) and its 9 day moving average (thin blue line).  So while prices were falling on the Shanghai and the MACD found new lows as well, the MACD histogram indicated that the MACD was not dropping as fast as its 9 day moving average, an early hint of an impending reversal if you will.  I prefer to see the positive divergence develop on the MACD, but I do take note of divergences on the histogram as well.

The Shanghai gained over 100% off of its October 2008 lows and started its climb well before the S&P 500 bottomed.  I find the sudden drop in Chinese shares somewhat alarming and would feel much better about the S&P 500 if the Shanghai breaks out of its current triangle to the upside.  Could the recent fall in China be a precursor to another quick drop here in the U.S.?  Well, I wouldn't rule it completely out, though we must remain focused on the here and now, not what could be.  So long as the major indices in the U.S. continue their uninterrupted climb and key price support levels are not lost, then I assume pullbacks can be bought.  Personally, I'd like to see additional selling on the U.S. indices down to their 50 day SMAs, a drop that would in my opinion reset the MACDs near the centerline and provide a better opportunity for another upside move.  A breakdown below the 50 day SMAs on increasing volume should absolutely be respected.

Price/Volume trends have remained bullish for the last several months.  However, that did begin to change over the last week as heavy volume accompanied selling after good fundamental news had been reported - ie, Intel's (INTC) raised guidance, higher pending home sales, much higher ISM reading.  As I always like to say, it's not the news that I focus on.  It's the market's REACTION to the news that's important.  I am short-term neutral to slightly bearish, while bullish the intermediate-term.  September has finished lower 35 of the last 58 years on the S&P 500, the only calendar month to finish down more than up since 1950.  It is the worst month of year, bar none.  History can, and many times does, repeat itself, so tread and trade lightly.

Happy trading!

LOOKING BACK

I continue to get mail from people who question how it is possible to be bullish in the face of the worst fundamentals since the Great Depression, so I thought it would be useful to look at a chart of the 1929 Crash and the decade that followed it.

Squeezed on the left side of the chart you can see the initial Crash and the rally that followed it into mid-1930. That was a bear market rally, and it advanced about 50% from the Crash low. While all our current signals are bullish, I still have no problem imagining our current rally ultimately resolving in this manner. The point, however, is that the big rally in 1930 occurred at a time that the fundamental problems had hardly been acknowledged, let alone solved.

After the final low in 1932 the market rallied for over four years and 300% during what has to be characterized as the depths of the Depression. I do not mean to assert that this is what I expect from our current situation, only to demonstrate what can happen and how fundamentals can often be at odds with price movement.

 

Moving back to the present, let's take a look at a weekly-based chart of the S&P 500. As of Friday's close, the 17-EMA crossed up through the 43-EMA by a thin, thin, thin margin of 0.03. This is the approximate equivalent of a 50/200-EMA crossover on the daily-based chart, and it confirms the long-term (months to years) buy signal we got on August 11.

What bothers me on this chart is the ascending wedge pattern, which looks more ominous from a weekly perspective than it does from a daily view. It is hard for me to imagine this wedge resolving any way but downward. I cannot picture in my mind a congruous price pattern that could result from an upside breakout. Once a correction is completed, more sensible possibilities could emerge. I guess this opinion falls under the heading of "gut feeling", but it comes from a person who has looked at a lot of charts for a lot of years.

Bottom Line: Medium-term indicators are still quite overbought, and a correction would be the best way to clear this condition. Is entirely possible that we have seen the top of the rally/bull market, but medium- and long-term signals are positive, so I think the worst case we should expect for now is a correction. Our medium-term timing model will switch to neutral from buy if the S&P 500 daily 20-EMA crosses down through the 50-EMA. 

BONDS AND GOLD LEAD THE WAY HIGHER

Intermarket analysis shows strength in bonds and gold, but weakness in the Dollar and oil. Strange days indeed. The Intermarket Perfchart below shows performance over the last sixty days, from June 11th to September 3rd. Relative strength in bonds is the first thing that jumps out. Performance for the 20+ Year Treasury ETF (TLT) has been positive the entire time (60 days). In contrast to bonds, oil is the weakest of the intermarket players. Except for a positive blip in early June, performance for the US Oil Fund ETF (light blue) has been negative since mid June. While bonds are up over 10%, oil is down over 10%. Could this be a sign of deflation? For one reason or another, money is clearly moving into bonds. It could be deflationary pressures, slower economic growth or a flight to safety. It is also interesting to note that oil moved lower even as the US Dollar moved lower. Oil usually benefits from weakness in the Dollar. The green line shows the Dollar Bullish ETF (UUP) working its way lower from mid June to early September. Weakness in the Dollar is, however, helping gold, which surged over the last few weeks (pink line).

Click this chart to see details.