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TECHNICAL ANALYSIS 101 - PART 15

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 entire series.)

Price charts often have blank spaces known as gaps. They represent times when no shares were traded within a particular price range. Gaps result from extraordinary buying or selling interest developing when the market is closed. When the market opens, the price is raised or lowered enough to satisfy all of the buying or selling orders.

For an up gap to form, the low price after market close on the day of the up gap must be higher than the high price of the previous day. Up gaps are generally considered bullish.

A down gap is just the opposite of an up gap; the high price of the down gap day after market close must be lower than the low price of the previous day. Down gaps are usually considered bearish.

Up and down gaps can form on daily, weekly or monthly charts and are considered a significant when accompanied with higher than average volume.

A price chart with gaps almost every day is typical for very lightly traded securities and should be avoided. Prices often gap up or down at market open and then close the gap before market close. Such temporary intraday gaps should not be considered as having anything more significance than normal market volatility.

Many investors mistakenly believe that gaps influence future prices to the point of eventually filling the gap. Instances where gaps close within a few days of forming can be significant. However, gaps have little to no influence on price action weeks or months after forming.

Breakaway gaps signal a change in market psychology about the future prospect of a security, especially when accompanied by above average volume. A bullish breakaway gap forms when a security gaps up after an extended decline, extended base or a consolidation period. A bearish breakaway gap forms when a security gaps down after an extended advance, an extended top or a consolidation period.

Common gaps occur within a trading range or shortly after a sharp move as a reaction. These gaps do not reflect a change in market psychology, but rather represent price volatility or temporary imbalance of supply and demand. For instance, if a security has declined 20% in a week and gaps up, it would be considered a common gap and not likely to signify a change in trend. Or, if a trading range develops between $20 and $30, and a gap forms in the middle, it is probably a common gap.

Continuation gaps form near the middle of a short or intermediate trend in the same direction. These gaps signal a continuation of the preceding trend. Continuation gaps are also known as measuring or runaway gaps. These gaps can be triggered by news events that bring more market attention to a security.

Exhaustion gaps occur in the direction of extended trends. For an exhaustion gap to be considered valid, prices should reverse soon after the gap and close the gap. In the later stages of a trend, the extent of the trend becomes widely reported; eventually causing a surge in trading that cannot be sustained. These events often mark the end of the trend.

Next time, we'll start looking at Candlestick Chart Patterns.

LONG-TERM RATES MOVING BEFORE STOCKS

The 10-Year Treasury Yield ($TNX) is largely positively correlated with the S&P 500 - and also shows a propensity to lead the stock market. The chart below shows the 10-Year Treasury Yield peaking in July 2007 and stocks peaking in October 2007, three months later. Similarly, the 10-Year Treasury Yield bottomed in December 2008 and stocks bottomed in March 2009, again 3 months later. The 10-Year Treasury Yield now has peaks in early June and early August. In addition, the 10-Year Treasury Yield broke below its July low with a decline into early October. Should the current pattern hold, the stock market would be expected to peak between September and November. This period is three months after the June peak and three months after the August peak in the 10-Year Treasury Yield ($TNX). If we take the middle, then that means an October peak for the stock market. So far the S&P 500 remains above its early October low and the medium-term trend has yet to reverse.

Click this chart for details.

SAFETY FIRST

It's very easy to get caught up in the euphoria of this market run.  I'd be careful to do that.  Invested Central turned from aggressively optimistic to cautiously bullish in early May and we've maintained that more cautious stance since.  Call us conservative if you'd like.  We view it as a compliment.  After all, if we don't protect our capital, who will?  Does anyone believe the folks on Wall Street have our personal best interests in mind? 

 

As I've mentioned in recent articles, price/volume trends are bullish near-term.  That can be all you need to forge to higher levels.  But we cannot ignore some of the risks associated with the market.  I like to follow the equity only put call ratio ("EOPCR") as an indication of market sentiment.  Currently, the 60 day moving average of the EOPCR is at .59.  Since the CBOE began providing the data, this ratio's lowest 60 day level has been .56.  Low levels mark investor optimism and overconfidence and generally sends red flags flying high.  Take a look at the 6 year weekly chart of the S&P 500 (coming off of the 2000-2002 bear market).  I've plotted the two .56 readings that have occurred:

 

It's important to note that extreme levels of investor optimism doesn't have to send the market plummetting.  It USUALLY suggests that we've simply come too far too soon and that the market could use a pause, or breather if you will.  Those last two readings of .56 that were plotted above didn't have any long-term implications.  Rather, the market rested for awhile after complacency set in.  Once complacency was no longer an issue, the uptrend resumed.  We're still relatively optimistic and bullish the intermediate- to longer-term, though we have lines in the sand should the market begin to fall again.  Everyone should have their battle lines drawn.

 

We're not to that .56 level just yet, but getting closer.  For only the second time since the CBOE has been providing the equity only data, the DAILY equity only put call ratio has been at that .56 level for 10 consecutive days.  I do want to point out that it may take a few weeks of continued optimism for the equity only moving average to hit .56.  So we have to trade what we see.  That means continue thinking long for now with price/volume trends bullish.  If you're nervous about the market at current levels, taking a breather and sitting in cash is not a bad option.  The major point here and in my most recent articles is that while the market remains on a buy signal, we need to view the clouds on the horizon with caution.  There may be a storm brewing in the distance.

 

Happy trading!

OIL ETF BACK ON BUY SIGNAL

In my September 25 article I headlined the fact that the Oil ETF (USO) had generated convincing sell signal, so I think it is appropriate to report that the signal has recently turned to a buy. Below is the chart from the 9/25 article showing the breakdown from the triangle formation that accompanied the sell signal. It still looks good to me, but that breakdown turned out to be a shakeout, a final decline clearing the market of sellers and setting up another advance.

On the next chart you can see how the shakeout lows redefined the lower limits and shape of the triangle. Prices rallied off the shakeout base and broke through the top of the triangle. Prices have also broken through the 200-EMA, so I think this move has a lot of credibility. Of course, I also thought the sell signal was very credible too, but we must change our opinion as the evidence demands.

Gold has also made a decisive break above important overhead resistance. I have been concerned that gold would not be able to do this because a rally in the dollar seemed imminent, but the dollar has failed to rally, and gold has shown its strength. At this point I wonder if the oversold condition of the dollar will lead it to decline even further. The technical expectation for gold at this point is for a pullback toward the recently penetrated resistance, now support.

Stock prices have continued to move higher in spite of broad expectations for a decent correction. Looking at the weekly chart of the S&P 500, we get a longer-term perspective. The price index is headed into an apex where the long-term declining tops line and the top of the ascending wedge pattern converge. It sure looks like a rally stopper to me. The crystal ball says rally top should be in place within a week or two.

Bottom Line: Breakouts in the prices of oil and gold indicate a lack of confidence in the ability of the dollar to rally. Stock prices are approaching long-term resistance, and there is a strong possibility that the rally will finally end. That is not to say that the bull market will be over at that point, but a healthy correction is overdue.

SHORT-TERM RATES AND THE DOLLAR

While there has been a negative correlation between the Dollar and stocks this year, there has been a positive correlation between the Dollar and short-term interest rates. The chart below shows the US Dollar Index ($USD) with the 1-Year Treasury Yield ($UST1Y). Both rose in January-February and then declined from March to October. Notice that stocks declined when these two rose and advanced when these two declined. While correlation is not the same as causation, there is clearly some sort of connection here. Therefore, we should be watching short-term rates for clues on the Dollar. A rise in short-term rates would be positive for the Dollar. Should the negative correlation between stocks and the Dollar hold, a rise in the Dollar would be negative for stocks. Right now, however, both short-term rates and the Dollar remain in clear downtrends, which is currently positive for stocks.

Click this chart for details.

NYSE AD LINE NEARS 2007 HIGH

NYSE ADVANCE-DECLINE LINE NEARS OLD HIGH ... One of our readers asked for a look at the NYSE Advance-Decline line, and this may be a good time to start keeping an eye on it. Chart 7 shows the NYAD nearing a test of its 2007 peak. What's surprising is that the NYAD has retraced nearly its entire downtrend while major market indexes have retraced only half. That's probably good news since the NYAD is viewed as a leading market indicator. One possible concern, however, is that the AD line may meet some resistance near its old high. That's why it's worth keeping a close eye on as its retests its 2007 high.

INTERNET CONNECTION AND DATAFEED UPGRADE REPORTS

Internet Connectivity Upgrade Progress Report:

On Monday night we moved our site traffic off of our old 180 megabit T3 connections and back onto the gigabit Fiber connection.  Later we ran a test of our new automatic failover configuration by physically disconnecting the fiber cable from its router and we saw that our traffic immediately moved back onto the old T3 connections.  We then plugged the fiber cable back in and traffic immediately moved back onto the fiber cable.

This means that we should not have a repeat of last month's site disruptions - at least not because of lost connectivity here at the StockCharts offices.  And that is a very good thing indeed.

(BTW, we have ordered a second gigabit fiber connection to replace the T3s as a backup circuit.  That second fiber circuit should be in place by the end of the year.)

Datafeed Upgrade Progress Report:

On the data feed side of things, we continue to have a frustratingly high number of issues with our ThomsonReuters datafeed.  The good news is that because we now also have the IDC/Comstock datafeed, the problems with the Thomson feed have not been as disruptive as they might otherwise have been.

For example on Thursday morning, completely out of the blue, the Thomson feed stopped providing us with US stock information as well as with delayed Canadian information.  If we had not had the IDC/Comstock datafeed here, we would have been unable to provide charts of US stocks at all.  The IDC feed saved us from disaster.

We are continuing to move more and more of our data traffic away from the Thomson feed because of these problems but the process takes time - among other things, we need permission from the numerous exchanges as we move the various indexes across.

Our goal is to have the ability to use either the Thomson or IDC feeds for all ticker symbols that we track.  When we get to that point, a failure of one feed shouldn't disable our charts.  Right now, we have that kind of redundancy for US stocks and may common indexes.  We are working on getting that same level of redundancy for all of our symbols and hope to have that in place by the end of the year.

TECHNICAL ANALYSIS 101 - PART 14

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 entire series.)

Fibonacci Lines

How high is "too high?" How low is "too low?" Think back to any time that you've owned a stock and think about when you started to get worried about it's performance. At what point did "your gut" start to tell you that you needed to sell? Chances are your gut started talking to you after the stock had moved up (or down) by 38.2%.

Wow, that's a really specific number - "38.2." It seems kind of arbitrary also. There's no way that could be correct, right? I mean, without knowing anything about the stock you were trading, or the amount of money involved, or the overall market conditions, or anything else - how can we stand here and tell you that you got nervous right at 38.2%?

The reason is because 38.2 appears to be programmed into the human psyche (as well as many other parts of nature). 38.2 is one of a set of numbers called "Fibonacci Percentages." They are derived from the "Fibonacci Sequence" which is a list of numbers where each number equals the sum of the previous two. i.e.,

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 etc.

The branching in trees, arrangement of leaves on a stem, the flowering of artichoke, an uncurling fern and the arrangement of a pine cone - all these things exhibit Fibonacci characteristics . In addition, if you take any large Fibonacci number and divide it by the previous number, you'll get something very close to 1.6180339887 (the larger the number, the closer you'll get). Now, 1.6180... has been known for centuries as "The Golden Ratio" - mostly because we humans tend to prefer things - art, sculptor, architecture, etc. - that have proportions that equal the Golden Ratio.

Which of these picture looks the most "natural" to you? The middle one has Golden Ratio proportions.

Getting back to stock charting, R.N. Elliott made the first well-known connection between price movements and the Golden Ratio. He noted that many reversals occurred around 61.8% or its compliment 38.2% (i.e., 100 - 61.8). Combined with 50% and 100%, they make up the standard set of Fibonacci Percentages.

Regardless of how the numbers were arrived at, chart analysts have observed that prices often will reverse after moving up (or down) by one of those percentages. Basically, those percentages are where something tells many people that it is time to take action - and thus prices reverse. Strange but true. Check it out:

The Fibonacci Lines on this chart were created based on the move from Feb. 9th to May 30th - so just focus on the shaded blue area of the chart. Like a weatherman, the lines "forecast" that support for IBM would occur around 118.35 essentially because lots of people would probably feel that IBM had "fallen enough" and would start buying it again. That is precisely what happened at the end of June (red arrows).

Unfortunately many people have gone on to claim that Fibonacci lines (and their variants) have almost "magical powers" to predict price movements. Like most Technical Analysis tools, we think Fibonacci Lines are useful forecasting tools - but not magical.

You can add Fibonacci Lines to your charts using our ChartNotes annotation tool. To get started, simply click on the "Annotation" link below any SharpCharts.

Power Tip:  If you hold down "CTRL" while drawing Fibonacci lines, we'll add the 23.6% and 161.8% lines as well.

Next time: Gaps!

BREAKDOWN IN BOND YIELD MAY BE BAD FOR STOCKS

One of the catalysts behind Thursdays heavy stock selling was the breakdown in Treasury bond yields. The 10-Year T-note yield fell below its July low to the lowest level in more than four months. Bond yields are an indicator of confidence in the economy. When investors are optimistic, they buy stocks and sell Treasuries. That pushes bond yields higher. When they're more pessimistic, they sell stocks and buy Treasuries. That pushes yields lower. So the direction of Treasury bond yields has some bearing on the direction of stocks. That's been especially true over the last two years. The weekly bars in Chart 1 compare the trend of the 10 Year Treasury Note Yield (TNX) to the S&P 500 (green line). At least two things are apparent. One is that bond yields and stocks have usually trended in the same direction. The second is that bond yields have tended to change direction first. Bond yields started dropping during the summer of 2007 several months before stocks peaked. Bond yields started bouncing at the start of 2008 and anticipated a stock rebound that spring. After falling together during the second half of last year, bond yields turned up several months before stocks. Chart 2 shows bond yields turning up in January of this year two months before stocks' March bottom. Bond yields peaked in June, however, and have been weakening since then while stock prices have risen. That "negative intermarket divergence" grew more serious with yesterday's breakdown in yields.

Major Indices Hit Major Resistance and Fail

I've cautioned recently about the risks of being long in the market.  There were too many warning signs.  Yes, the market could have kept its head down and pushed to higher levels.  But that wouldn't have been the healthy way to extend the recent uptrend.  Many of the major indices failed at critical long-term resistance and now must regroup from lower levels as they approach key short-term support levels.  I'm featuring a few key indices/ETFs in order to highlight the importance of the resistance levels tested.  Check these out below:

I used the SPY chart above instead of the S&P 500 in order to reflect the gap resistance present on SPY that doesn't appear on the S&P 500 chart.  Notice how the price of SPY climbed almost exactly to the top of that gap before failing and rolling over to the downside.  Sellers were lined up at that level, knowing full well that a close above gap resistance would likely trigger more short covering and more technical buyers.  The failure on this first test should come as no surprise.  You can also see that the technology-laden NASDAQ and the economically-sensitive transports also failed at key resistance.  Given the recent overbought conditions, negative divergences on the MACD, and complacency readings on the equity only put call ratio, a pullback was very much needed.  In my last article, I indicated the record number of equity calls traded on September 16th and 17th.  Take a look at the NASDAQ 30 day chart below to understand why following this sentiment indicator is so important.  The combination of a very low equity only put call ratio AND the high volume of options traded suggested that an important top was forming, just as it did in early May.  While the top didn't occur exactly on September 16th/17th, the market had little fuel in the tank after the extreme complacency readings that were mentioned two weeks ago.

Many of the red flags that have tormented the market the last few weeks have been eliminated, making it easier for the uptrend to resume.  However, we must all be aware of the fact that the July breakout occurred from much lower levels and that the 50 day SMA may not necessarily hold as support near-term.  A final line in the sand should be drawn at the price level where June highs were eclipsed during the July uptrend.  That's your critical price support level.

Happy trading!

COMPLACENCY IN THE MARKETS

Complacency, complacency and more complacency. While the media worries about a correction in the strong cyclical bull market, they should quite simply be considering whether or not the cyclical bull has indeed topped out and a cyclical bear market has begun. This is the nature of higher prices; market participants tend to extrapolate the present far into the future - and this is what most market participants are doing right now.

To wit, note the CBOE Volatility Index ($VIX) has forged a low at the 23 level after having traded to mind-numbing 80. Where everyone was bearish the broader market at the highs; they are bullish at the lows. But the lows now look to be turning higher once again, and we should see traders start to notice that trendline resistance was in fact given in bullish fashion; we should further note that the weekly stochastic is turning higher from oversold levels once again. In the past, this has increased the probability of a larger market decline than not; so buyers should be beware. The time to have been bullish is past; the time to consider bearish positions is here. Rallies are to be used to put on short positions; not dips to be buyers. There is a distinction; and it is important to one's trading health.

SUPPORT STILL HOLDS CORRECTING PRICES

The market has begun another correction, but so far no serious technical damage has been done. The S&P 500 remains within the grasp of an ascending wedge formation, the dominant feature on the daily chart. On Friday prices hit their lowest level of the correction, but they remained above the support of the 50-EMA and the rising trend line. Next major support is at the 200-EMA.

As regular readers know, it is most likely that prices will break down from the rising wedge pattern, and I am inclined to believe that will happen in this case. Internal conditions for the medium-term are neutral to slightly overbought, and I think the market needs to get medium-term oversold before the correction will end. Also, it is October, and a certain amount of ugliness should be expected. I hear that a number of people are expecting a crash, but I see no evidence that would make me anticipate anything more than a normal correction.

The following Participation Index (PI) chart shows that the short-term market condition is oversold. This could signal a short-term bounce, or the end of the correction. The latter is unlikely because the market needs to get more oversold medium-term before another up leg begins.

Bottom Line: It is very likely that the S&P 500 will break down out of the rising wedge pattern soon. With luck a breakdown will be followed by a healthy correction, but we are in a bull market and I wouldn't bet on anything worse than that.  

TECHNICAL ANALYSIS 101 - PART 13

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 entire series.)

The Infamous Head and Shoulders Reversal Pattern

One of the most common reversal patterns is the Head and Shoulders pattern. 

This pattern forms in an uptrend and its completion marks a trend reversal.  The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being lower.  The reaction lows of each peak can be connected to form line of support called a neckline. The top reversal pattern is completed when price breaks below the neckline.

While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights.

It's important to realize that up until the point where prices move back below the level of the left shoulder, things look like a normal, ongoing uptrend.  It is only when the left shoulder's price level is violated that the bulls become fearful and the bears start to smell blood.  The right shoulder forms as the bulls try to reestablish the uptrend and then fail - usually because many of the more skittish investors will take profits at that point.

As the Head and Shoulders top reversal pattern unfolds, volume plays an important role in confirmation.  Buying volume (volume on up days) will slowly translate into selling volume (volume on down days) as the pattern develops.  This is seen when volume that previously expanded on rallies begins to expand on declines and contract on rallies. 

The Head and Shoulders bottom reversal pattern is just the reverse of the top reversal pattern with volume acting as a confirmation. 

As with the Head and Shoulders top reversal pattern, volume action is helpful in confirming the trend reversal.  Volume that was previously expanding on declines begins to expand on rallies and contract on declines as the trend reversal develops.

Traders begin noticing lighter selling volume on the declines and heavier buying volume on the rallies.  This kind of price and volume action is quickly noticed by the market which results in additional buying volume supporting the trend reversal.

A couple of other comments about this pattern:

• Sometimes several left shoulders will form before a true head appears.  Sometimes several right shoulders appear before a true neckline break occurs.
• When a neckline break occurs, the stock will often fall at least as much as the distance from the neckline to the top of the head.
• Head and Shoulder patterns are easy to find but hard to confirm.  Make sure that the pattern is based on real fear/greed and confirmed by volume before acting on it.

Other Reversal Patterns

Many of the technical analysis books out there will go on to talk about several other kinds of reversal patterns - the rounding bottom, the V-reversal, double tops, triple bottoms, and others.  (We have many of them cataloged in our ChartSchool area.)  I'm going to tell you a secret - most of those are just variations of the Head and Shoulders reversal which didn't form "perfectly" for some reason.  For example, the triple top is a Head and Shoulders pattern where the head didn't go above the left shoulder.

The key point here is this - don't worry about what type of reversal is occurring.  Knowing that it's a triple top instead of a H&S top won't make you more money.  Focus on the fact that the chart is telling you that the fear/greed ratio is changing and react accordingly.

Next time, we'll look at the question "how much is too much?"

BREAKDOWN IN BOND YIELD MAY BE BAD FOR STOCKS

One of the catalysts behind Thursdays heavy stock selling was the breakdown in Treasury bond yields. The 10-Year T-note yield fell below its July low to the lowest level in more than four months. Bond yields are an indicator of confidence in the economy. When investors are optimistic, they buy stocks and sell Treasuries. That pushes bond yields higher. When they're more pessimistic, they sell stocks and buy Treasuries. That pushes yields lower. So the direction of Treasury bond yields has some bearing on the direction of stocks. That's been especially true over the last two years. The weekly bars in Chart 1 compare the trend of the 10 Year Treasury Note Yield (TNX) to the S&P 500 (green line). At least two things are apparent. One is that bond yields and stocks have usually trended in the same direction. The second is that bond yields have tended to change direction first. Bond yields started dropping during the summer of 2007 several months before stocks peaked. Bond yields started bouncing at the start of 2008 and anticipated a stock rebound that spring. After falling together during the second half of last year, bond yields turned up several months before stocks. Chart 2 shows bond yields turning up in January of this year two months before stocks' March bottom. Bond yields peaked in June, however, and have been weakening since then while stock prices have risen. That "negative intermarket divergence" grew more serious with yesterday's breakdown in yields.

Chart 1


Charts 2
 

QQQQ Tests the 50-day

With a sharp decline over the last eight days, the Nasdaq 100 ETF (QQQQ) is testing support from the rising 50-day moving average and RSI is testing support around 45-50. QQQQ broke the 50-day moving average briefly in July, but held the 50-day during the May, June, August and September pullbacks. Some bounces were bigger than others, but the moving average held for the most part. A clean break below the 50-day would be negative for the current uptrend.

Click this chart for more details.

The bottom indicator window shows 14-day RSI. Notice the support zone around 45-50. RSI held this support zone in May, June, August and September. Again, the only breach of support occurred in July (red arrow). This also coincided with the breach of the 50-day moving average. With RSI again in this support zone, a momentum test is upon us. Failure to hold this zone would be negative for momentum and possible signal the start of an extended correction.

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!