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Trader's Corner

Why the Fall?

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Someone came over to my office today and excitedly asked about the steep decline today and asked what was going on with the dollar. Well, it's in the nature of the media to point to some trigger or cause, as if a steep drop at this juncture was unexpected except for some triggering 'event'. And, of course the dollar is going down. Given our huge trade imbalance and latest interest rate cuts, foreigners are not so eager to hold our greenbacks. While others wonder why the market fell off sharply recently (isn't it 'supposed' to keep rising!), I kind of marvel that speculators and investors kept bidding up stocks in the face of serious dangers of a possible economic slowdown.

(from the desk of a technical trader)

1.) Declines or corrections in the market are more often steep than gradual, particularly in long-term bull markets. Selling tends to be more of a one-time decision; e.g., a big fund manager sees the market stalled and decides he wants to raise 1 percent more cash and sells a half billion dollars worth of stock. Buying tends to occur in multiple and gradual increments on the way up. We love to buy, hate to sell, but when we do, it tends toward panic selling in individuals.

2.) Sales of a lot of things, appear to be slowing down, judging from the loss of major long-term upside momentum in the stocks whose business it is to transport all those widgets from one place to another. With oil near $100, this is impacting those companies' earnings of course. Dow Theory is exactly about situations where one of the two major Dow averages, (the so-called Dow 'Industrials' and the Dow Transportation average) fail to move in tandem with the other; i.e., one Average or the other doesn't also follow to a new closing high or fall to a new closing low.

I wrote last month in a Trader's Corner column about the Dow Theory 'warning' suggested by the Dow Transports (TRAN) seriously lagging the Dow 30 (INDU). Not only was TRAN looking unlikely to join INDU anytime soon in the new Dow closing high made in the week ending 10/12, but TRAN was also falling well under its long-term up trendline showing a loss of momentum. My first graphic of TRAN and INDU are their close-only weekly 'line' charts, with a Friday (weekly) close that is still undetermined of course; the last point on the lines are today's closes.

Anyone, wanting more of the background on Dow Theory can backtrack to my earlier article on the Option Investor web site by clicking here.

3.) There was technical 'resistance' apparent at the recent highs in the major stock indexes, if you knew what to look for. Fortunately, Option Investor.com subscribers, that's you wise people, had some forewarning about this, also in this space last month and in my Index Trader columns seen online on the weekend. I'll update a couple of these weekly charts with the broad uptrend price channels that I constructed. Step by step instructions for constructing trend channels can be reviewed by going back to my 10/24 Trader's Corner by clicking here.

The S&P 500 (SPX) weekly chart seen next below provides my first example of how a line drawn parallel to a major up trendline and touching 1-2 or more prior tops, can intersect much later at an area that brings in significant selling/resistance.

Moreover, just as the Dow Industrials and Dow Transportation averages had a bearish 'divergence' in their respective trends, there was a clearcut divergence between the higher highs seen in SPX below and what the 13-week RSI (Relative Strength Index) was doing. Prices were going up, while 'relative strength' was declining. Such bearish price/indicator divergences can be another tip off not to get 'too' bullish; although stocks looked like they could 'only' go up, there were these technical warnings.

A second broad weekly uptrend channel is outlined on the Nasdaq Composite (COMP) chart seen next. Looking at the 13-week RSI shown under the price chart, the feature here wasn't a question of a bearish DIVERGENCE between price action and the indicator at the recent high, but 'resistance' implied by an 'overbought' reading (in the 67-70 zone) associated with past tradable tops. The combination of the rise to resistance implied by the top end of the uptrend channel AND the overbought reading was a double tip off that COMP had reached an area of significant resistance.

4.) Technical warnings of a possible downside correction in the Nasdaq were also suggested by the 'rising wedge' chart patterns seen in the daily charts of Nasdaq Composite (COMP) and the Nas 100 (NDX) and pointed out in my most recent (Saturday) Index Trader article.

The pattern in the two key Nasdaq indices, one of which is seen below (Nas 100, NDX), is that of a bearish rising 'wedge'; i.e., an upward trend bounded by two intersecting, up-sloping, trendlines. This pattern sometimes points to a bearish short-term (up to 3 months) trend reversal, with decline potential of 9-15 percent on average when such a decline occurs and prices break out of the wedge pattern.

With stocks, the bearish wedge pattern is only so-so in predicting later trend reversals, but this pattern has a relatively better record of prediction when seen in the major stock indexes. I point it out here because it is considered a bearish chart pattern, but without the strong record of prediction provided by such patterns as a double top, double bottom, Head & Shoulder's top, etc.

The pie shaped pattern made by extending the lower and upper trendlines out to a point of intersection makes the 'wedge' part of a bearish rising wedge. It's a somewhat unusual chart pattern not seen all that much, but in about half the instances I've seen of the rising wedge in the major indexes, it's led to a steep correction after there's a decisive downside penetration of the lower trendline. Whether NDX has as much downside potential in coming weeks as to fall back to the 2038 area (a 9% correction) or lower, remains to be seen. Stay tuned on that!

As was seen with an earlier chart example, prices were rising while NDX's 13-day Relative Strength Index (RSI) seen above was declining, a technical divergence suggesting that the index could be in a for a sharp price break at some point; 'SOME' is the operative word here, as just when such a fall will occur has to be watched closely for.

Big cap tech stocks have been very strong and a bullish view prevails. There's a bearish warning provided by the foregoing chart and indicator patterns. Even the best performing stock groups cannot usually resist an overall market decline.

5.) Clear and present danger of an upcoming trend reversal occurs when traders get overly bullish (danger of a downside reversal) or overly bearish (increasing likelihood of an upside reversal). The question is how do you measure such bullish or bearish 'sentiment' and as anyone who follows my particular way of doing that will be familiar with the indicator shown at bottom of my last chart below, that of the S&P 100 (OEX):

The last peak reading noted at the red down arrows above indicated an extreme in bullishness; readings at and above the upper (level red) line, are considered to represent an 'overbought' extreme and suggests a possible downside trend reversal within 1-5 trading days. This last peak in bullish sentiment occurred 1 day before this latest steep correction began. Once such corrections begin, they are usually intermediate-term in duration; e.g., of a 2-3 week or more duration rather than short-term of 2-3 days duration.

The peak indicator reading (at the upper red line) PRIOR to this most recent one, preceded the top made at 735 in OEX by exactly five days.

NOTE: The 'CPRATIO' line seen above is the result (a ratio) of dividing total daily CBOE equities call volume by total daily equities put volume. I calculate the number daily from the CBOE web site figures for equity options call and put volume. I used to just keep a simple written record of the daily call to put volume number, before I could graph this 'custom' indicator in my TradeStation software. 1.9-2 and above, marks an overbought/overly bullish extreme in the bullish/bearish sentiment spectrum. 1.1 or below is an extreme in bearish sentiment or the outlook for stock prices as reflected in the collective decisions of a lot of option traders.


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