Option Investor
Educational Article


Printer friendly version

Sometimes in the day to day news, price fluctuations and minutia of trading, it is easy to lose sight of the big picture. For every voice calling the market "a bargain" with "compelling values", there is a competing voice telling us all the risks that currently exist, followed by a prediction of DOW 5000 or lower. What's an investor to do? Trust their own eyes!

I've already gone on record at the beginning of the year, stating my belief that while 2003 is going to be a rocky year, the broad market will finish up with a gain, avoiding the dreaded 4th consecutive down year. But it isn't going to be a pretty process getting there. If you missed my bold prognostication, feel free to experience my thoughts vicariously at the following link.

'Tis The Season

As traders, the eventual destination is far less interesting, when compared to understanding the path we are likely to take in reaching that destination. As the LEAPS editor, my primary focus is on the weekly and daily charts, as that is where I attempt to identify the trend that is likely to persist over a period of weeks and possibly as long as 3-4 months. A quick look at the weekly and daily chart picture right now tells us that the broad market is attempting to recover from the very oversold conditions produced by the past 2 months of rather persistent selling.

While Bullish Percent charts are either in or very near oversold territory, we know that bears are now carrying the bulk of the risk over the near term. But that doesn't mean that bulls are safe to plunge in with the expectation that last week's lows were the bottom of the most recent broad market slide. For this sort of discussion, I find charts do a much better job of depicting what I'm talking about than my words do, so I'm going to rely heavily on them today. I'm only going to use one indicator, Stochastics for our discussion today. That doesn't mean I don't use others as well, but I think they will be most useful for our purposes here today. Most of the time, I tend to rely on the (10,5,3) settings, as it achieves a good balance between filtering out the noise, while at the same time giving me good responsiveness to trend changes. To keep our discussion simple, let's just focus on the S&P 500 (SPX.X).

Daily/Weekly Charts of the S&P 500

As you can see in the charts above, the weekly timeframe gives the appearance of a bottom being formed in the SPX, and the daily view is giving an early hint of a recovery. We know that the catalyst for the rebound from last week's lows is a combination of a relaxation of war fears, along with the necessity to work off what had become a severe oversold condition. That oversold condition has been significantly relieved over the past few days, but with the bullish percent of the SPX still up at 34%, it is clear that there is still some significant downside risk at play. There is nothing to suggest that the dominant downtrend has changed, at least on the weekly chart, and the bulls will need to be extremely cautious until that major resistance just over 860 can be broken with conviction. That seems an unlikely development without more clarity on the geopolitical front.

Should the market get a favorable resolution to what has become the dominant topic of discussion of late (Iraq), then we really could get another decent rally. What it will likely take to give us an early indication that the next rally is underway will be for the daily Stochastics to fall back into oversold and turn up without price breaking below the lows of last week. But more importantly, at the same time, we'll need the weekly Stochastics to confirm the potential for a significant bullish move with an emergence out of oversold territory.

But that just determines what I call the intermediate direction for this market. My intent here is to focus on the bigger picture -- the dominant trend that I think will remain in force for some time to come. In order to view that trend, we really need to zoom all the way out to a monthly chart.

Monthly Chart of the S&P 500

What we have here is a descending channel that has encapsulated price action in the SPX for the past 3 years, and that trend is not looking like it is about to change anytime soon. The only possible constructive sign is the possible bottom forming in the monthly Stochastics oscillator. The last time the picture looked like this was in the fall of 2001, as the market began to recover after the 9/11 tragedy. And we did get a decent rally from that point, which brought the Stochastics up to the 50% level, but that's it. Price action stalled right at the upper channel line and then rolled over with force throughout last year. If price action breaks below the center-line of the channel (near 800), then we are faced with the very real risk of visiting the bottom of that channel again. Such a breakdown will more than likely have the monthly Stochastics falling into oversold and setting up a strong rebound, once they emerge back above the oversold region.

Believe it or not, I don't see that as the most likely outcome this time around. I think we'll actually rebound and challenge that upper channel line. But I think that test will fail with Stochastics rolling near (or below) the 50% level again. It's the culmination of that downdraft towards the end of the year that I think has the potential to provide a really powerful end of year rally. As you can see, it will have to be a powerful rally to provide a positive close to the year, as it will have to break above the top of that descending channel to get the job done. We started the year with the SPX trading near the 880 level and by the end of 2003, the top of the channel will have fallen to about 750. Either the SPX breaks out of the channel to the upside or we're going to have an uglier 2003 than even I want to contemplate.

My intent here today isn't to predict where we're going, or paint a dire picture of a possible worst-case scenario. Rather, as the title "Perspective" indicates, I wanted to provide a reminder (to myself as much as you) that we must keep in mind the BIG picture if we are to stay on the right side of the dominant trend. If you want to really have some fun, look through some of your favorite long-term stock holdings in this manner. We are all accustomed to looking at the daily and weekly charts, but I think we all too often neglect to view the really long-term picture. I think you'll find it interesting how some of those stocks that look good on the shorter-term charts lose a lot of their lustre (in a bear market) when viewed on the monthly charts. Find a stock that looks good on all three time frames, and odds are you've got a real winner for the long-term.

Questions are always welcome!


Options 101 Archives