Option Investor
Trader's Corner

Near-Term Technical and Far-Term Fundamental Market Analysis

HAVING TROUBLE PRINTING?
Printer friendly version

Chart patterns (support/resistance, gaps, bull flag), inflation, employment and the yield curve

CHART GAPS
Last week in my Trader's Corner column, I wrote about the concept of rising and declining chart 'gaps' that are created by sharply lower or higher openings relative to the previous day and caused by big order imbalances. Big buying interest means that stocks have to be marked up to lure sellers and big selling interest means that stocks have to be marked down to attract buyers.

I start with this concept of gaps again because we saw the major indexes gap higher today. Moreover, the low end of the gap seemed to where support/buying interest was coming in on the minor pullbacks that occurred today. One thing we often see with chart gaps is that they mark areas of support or resistance, depending on which way the trend is moving.

Gaps are not seen all the time, but are not so infrequent either. To see a fuller explanation than my short synopsis here, you can go back to my last Trader's Corner column (Wed, 9/12 OI Daily) by clicking here.

You have to turn to hourly charts to see S&P chart gaps as the daily index Open substitutes the prior night's closing prices for stocks with order 'imbalances' that don't open immediately. This convention by Standard & Poor's masks' gaps so to speak. Not so in the Nasdaq.

Before I turn to some charts, I would just note that upside chart gaps tend to signal still higher prices, downside gaps still lower prices ahead but this pattern doesn't usually have a measuring implication to suggest a further upside or downside objective. The exception to the forecasting value of chart gaps suggesting still more upside (or downside) ahead, sometimes after a prolonged move (up or down), a gap ends up being a so-called 'exhaustion' gap, marking the END or near the end of a move. I don't think that's what we saw today but stay tuned on that!

I've marked the upside chart gap on the S&P 500 (SPX) hourly chart below with the yellow circle. Prices pulled back a bit 'into' the gap created between the low of today versus the high of yesterday. The top end of an upside gap like this will often be as low as a subsequent pullback will get before another rally sets in. It gives us an idea of possible technical support at 1520. More pivotal technical support should be found in the 1500 area. Another technical rule of thumb is that after a key prior high is pierced, that prior resistance should 'become' a new area of support.

I was a disbeliever that the Fed would cut a full half percent or 50 basis points and that the major indexes probably would not rally all the way back to their July peaks. Of course this hasn't happened yet either but it looks like it can. Just on a technical basis and putting my long-term 'fundamental' concerns aside, the pattern off the lows was one of ever higher pullback lows as highlighted by the blue up arrows below. This pattern suggested that a bullish chart was the best interpretation until and unless prices topped out again around 1500 in SPX.

FLAG PATTERNS
The sharp run up (the 'flagpole'), followed by the backing and filling that that creates a downward sloping formation that looks like a 'flag', is often a consolidation before a next up leg. There is a measuring implication to this pattern in the second leg or height of the flagpole is going to at least equal the distance that the next move will carry; suggesting, in this case, a 'minimum' upside objective to around 1585. We'll see.

OVERBOUGHT/OVERSOLD INDICATORS
Working somewhat contrary to the bullish flag interpretation I note above, there is also a significant tendency for EXTREMES registering in the 21-hour Relative Strength Index (RSI) indicator to mark at least temporary tops or bottoms as noted above with either the red down arrows or the green up arrow above on the RSI graph.

Looks like you have a technical interpretation that could suggest that SPX is only about half way in move that will carry fairly quickly to new highs for this current move higher, or an interpretation that suggests prices would more likely pull back some to adjust or consolidate recent gains. If there were a pullback within a still strong bullish trend, I'd expect good support/buying interest to develop in the 1500 area, before the index was in a position to challenge its July top.

Not surprisingly TECHNICAL analysis can point to different possibilities for the direction of stock prices. It's not surprising because, this is the way of economic or FUNDAMENTAL analysis, which I'm going to also delve into shortly. The different forms of analysis are just different ways of interpreting the same underlying market dynamics.

The NASDAQ Composite (COMP) hourly chart picture and interpretations are the same as the S&P 500 regarding the:
-bullish pattern of higher pullback highs that led into this latest strong surge higher
-strong upside breakout above resistance implied by the prior 2644 high
-bullish upside chart gap, and minor consolidation after that, that looks like a pause (bull flag) only, with still substantial upside potential
-overbought extreme suggested by the RSI indicator that might signal a pullback first.

FED ACTION, EMPLOYMENT AND THE YIELD CURVE:

Many were seeing significant danger signals for a deep economic slowdown, even recession, as signaled by an INVERTED YIELD CURVE. Alan Greenspan rated the chance of a U.S. recession as being somewhat more than a 1 in 3 possibility. I was one of those thinking that the Federal Reserve, especially the Chairman, were going to be too concerned with inflation to take the stronger medicine signaled by the 50 basis point cut that it surprised the market with yesterday.

A 'normal' yield curve is a 'positive' curve. Generally when the yield curve is positive, it indicates that investors are requiring a higher rate of return for taking the added risk of lending money for a longer period of time. The belief and long-time experience with it, is that a steep positive yield curve indicates that investors expect strong future economic growth and higher future inflation and thus, higher interest rates.

A sharply inverted yield curve means investors expect sluggish economic growth and lower inflation and thus lower interest rates. (A flat curve generally indicates that investors are unsure about future economic growth and inflation.)

BBecause the yield curve is so indicative of future interest rates, which are then indicative of an economy's expansion or contraction, yield curves and changes in yield curves convey significant forecasting information. A study done in the 1990s found that inverted yield curves preceded the prior FIVE U.S. recessions. Since stock prices are all about the bullish or bearish expectations for EARNINGS, a sharp slowdown is going to kill a bull market.

YIELD CURVE OUTLOOK COUPLED WITH THE EMPLOYMENT TREND:

Floyd Norris, who writes on the economy and business for the New York Times and is an intelligent read usually, suggested that the two charts below (forgive the poor reproduction!), with one representing a particular way of looking at an inversion in the yield curve AND the downtrend trend going on in the percentage of the U.S. population that are employed, is suggesting some danger of a future recession.

The top chart below shows the spread in yields between the 2-year T-note and Fed funds. The bottom chart shows the 6-month change in the percent of the overall population employed in the U.S. It's the combination of the underlying conditions signaled by the inverted yield curve and weak employment trends that the Fed did appear to recognize fully in their strong action of this week.

In normal times, the Treasury rate is usually higher than the Federal Funds rate, EXCEPT before the 1990 and 2001 recessions. At the widest spread recently, the 2-year Treasury note yield was 3.85 percent, while the fed funds target rate was 5.25 percent. The difference of 1.396 percentage points was the widest since early-January 2001.

Floyd Norris in his reporting noted that "It was also in January 2001 that the Fed surprised the market with a 50 basis point reduction in the target rate for fed funds. That move briefly cheered the stock market, but did not prevent the recession that began in March." The Fed, as I said before can waive its magic wand to lower interest rates but this medicine doesnt always cure the patient.

EMPLOYMENT:
The lower chart seen above shows the 6-month changes in the number of people with jobs, as reported by the Labor Departments household survey. In a growing economy, with the labor age population rising, the number of jobs almost always increases; but, not recently of course.

The August employment figures showed 145,794,000 people with jobs, or 125,000 fewer than in February. When that six-month change rate goes into negative territory, it has been a warning of economic slowdown. As can hopefully be made out in the chart above, the sharp dip in jobs seen July 1990 was also the month in which a recession began. A warning of the 2001 recession arrived in July 2000 in these figures, but few took it seriously.

IIf a recession does arrive there may be criticism that the Fed was too slow to cut interest rates as suggested by the warning of an inverted yield curve, and that it focused on inflation for too long. Stay tuned on that!

INFLATIONARY PRESSURES:
The above is not to say that inflationary pressures are something to be ignored; controlling inflation is also a key Federal Reserve mandate. We've seen the great economic boom in China putting upward pressure on all kinds of industrial commodities prices; e.g., copper. A more basic commodity for all and especially in the energy hungry U.S.A. is OIL.

The closing price of nearby crude futures today in New York was nearly $82 a barrel. We seem to have come to taking such high prices in stride and you often hear the talk about the inflation-adjusted price of oil not yet equaling the all-time (inflation-adjusted) peak of around a $100 a barrel.

SStill, with the weakness in housing and jobs slowing consumer spending already, the added impact of higher gas prices and especially heating oil in the weeks and months ahead, is a cause for concern.

I can only say I GLAD I don't have to perform the Federal Reserve's delicate balancing act. Not unlike the conflicting picture seen sometimes in the technical outlook that makes the right trading decisions a very tough proposition at times!

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.

GOOD TRADING SUCCESS!
 

Trader's Corner Archives