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Trader's Corner

Short and Long-Term Indicators Helpful in the Current Market Cycle

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Someone asked me to assess and re-visit the indicators I examined last week in my Wednesday Trader's Corner (3/26) to see what worked and didn't work to predict the most recent price swings. Seems like a good idea; if indicators or chart patterns don't prepare us or predict, to some degree anyway, trading opportunities, they aren't of any practical use and why use them. I got into technical analysis because I thought it offered the best set of tools for market 'timing' and I was always a trader type. I admit it, I like the action and that I can see if I'm right on the trends quicker and the learning process is speeded up. Sometimes it comes too fast!

So the first thing I looked at was the use of short-term models that are potentially useful to predict shorter term trend shifts and reversals, especially the use of the 21-period Relative Strength Index (RSI) for stock indexes; this momentum and overbought/oversold indicator also works reasonably well on actively traded bellwether stocks; e.g., GE, CSCO, AAPL, etc.

USING SHORT-TERM TREND MODELS:

USE OF THE 21-HOUR RSI (RELATIVE STRENGTH INDEX)
Just to repeat (skip this if you've know this from last week or because you just know it): RSI is a ratio line that measures the 'relative strength' of X number of higher closes VERSUS X number of lower closes. Up or down closes can be calculated on an intraday, daily, or weekly basis. The number of periods is the 'length' setting. If set to 21 the RSI measures 21 closing periods on whatever chart you select; e.g., hourly, daily, etc.

RSI also will define an 'overbought' extreme, such as when the RSI registers at or above 65, typically 70, or when the underlying instrument is 'oversold' by registering at or below 35, typically, 30 or under on either daily or hourly charts ('length' setting set to '21').

The length setting is a key input. For the hourly RSI, I use '21', a fibonacci number and one that I have found best defines extremes that develop after strongly trending periods of a few days. In 3 trading days, there are close to 21 hourly closes. [Also, a bullish or bearish 'divergence' sometimes develops where price and RSI trendlines slope in opposite directions. A bullish divergence has prices trending lower as RSI starts trending up; i.e., higher 'relative strength'. A bearish divergence is where prices are trending higher but the RSI is declining on balance.]

BUYING AND SELLING OVERBOUGHT/OVERSOLD SHORT-TERM EXTREMES:
Below is the hourly S&P 100 (OEX) chart that reflected the close of LAST WEDNESDAY, for comparison to this week's hourly OEX chart.

I noted last week that a ... "more conclusive OVERSOLD reading was reached at the beginning of the week (chart, as of 3/26, below), per the down red arrow to the right on the OEX hourly chart below"... and this suggested at a minimum that the index at that time might well fall back from its rally peak. There have been few to no instances so far this year, of prices surging still higher after registering an overbought extreme on a 21-hour basis. There have also been far fewer 'oversold' extremes seen than 'overbought' readings so far in 2008:

THIS WEEK'S HOURLY OEX CHART (THROUGH TODAY, WED, 4/2):

Given the second overbought extreme (see red down arrow, on the far right with the RSI indicator) AND the approach to the prior 638 high presenting a possible double top (maybe NOT), it wasn't surprising to see at least a pause in the OEX and a consolidation or sideways movement; one that would 'throw off' the overbought extreme, which has been initially borne out today (Wednesday) by the pause in the very strong upside momentum seen yesterday (Tuesday).

A similar hourly chart pattern exists with the Dow 30 (INDU) and Nasdaq charts; whereas I showed the hourly INDU chart last week, there is no point in showing it again as, in terms of the price and indicator pattern, there is little difference that shows up in terms of price or the indicator pattern. The Nasdaq Composite and Nas 100 are showing a similar 21-hour overbought extreme, only NDX has broken out to a new recent high.

Stay tuned for what the rest of the week brings. There are some INTERMEDIATE-TERM indicators that will be discussed next that have been suggesting for awhile that this market could do better on the upside than many expect.

INTERMEDIATE TREND CONSIDERATIONS:

HIGH BEARISH SENTIMENT OFTEN SIGNALS AN OPPOSITE DEVELOPMENT:
To date, there has not been a single rally in the major stock indexes that has carried above a prior rally high, but the S&P is now approaching that test. For example, in the S&P 100 (OEX) daily chart seen below, a move above 638, with an eventual close above 648, that wasn't quickly reversed (e.g. in the following 1-2 days), would suggest that the intermediate trend had turned up. The fact that the recent pullback ALSO held the 21-day average, a most useful moving average in assessing the trend, is a bullish plus.

As per last week, most readers of this column have heard from me before on the theory of why high bearish sentiment can be an indication that the market is making an intermediate to long-term bottom; even if this turns out to only be an 'interim' bottom that will be 're-tested' later; as was true at the end of the bear market in 2002-2003.

The recent very LOW bullish sentiment (high bearishness) seen above at the points of the up arrows, has set the stage for the strong rally of yesterday and only a minor retracement of that move today. An extension of this recent rally, perhaps after a pause, given the SHORT-TERM overbought condition described above, may end up carrying further than traders expect currently.

I took at as bullish that trader sentiment yesterday and today doesn't reflect a surge of call activity relative to puts. When traders finally get bearish, and sentiment makes a definite shift (it is a 'lagging' indicator), finally often sets the stage for a more prolonged rally than seen up to that shift.

A TECHNICAL MODEL THAT ASSESSES STRONG/WEAK INTERMEDIATE TRENDS:

The explanation of ADX that follows is also from my last week's Trader's Corner and I will repeat the explanation of the ADX as I want to update that chart also, as the indicator may begin to turn UP, suggesting that a trend is developing again instead of the back and forth 'whippy' action seen so much; a trend that I suspect will be up.

The Average Directional Index (ADX) attempts to evaluate the STRENGTH of a current trend, be it up or down. The inventor, Welles Wilder, came up with the ADX when trading the commodities markets and the stock market isn't as volatile generally so the scale is less extreme.
The ADX is an 'oscillator', an indicator that fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 50-60 are relatively rare even in the more volatile commodities markets, but in stocks and stock indexes, readings above 35 are unusual. Low readings, below 20 down to 15 indicate a weak trend; readings above 30 in the major stock market indexes indicate a strong trend.
The ADX indicator does not grade the trend as bullish or bearish, but assesses the strength of the current trend; i.e., readings above 30 can indicate a strong downtrend as well as a strong uptrend.
ADX can also be used to identify potential changes in a market from trending to a weak trend or non-trending. When ADX begins to strengthen from the 15-18 area and moves above 20, it is a sign of a developing trend. When ADX begins to weaken from above the 33-35 area and then moves below 28-30, it is a sign that the current trend is losing strength.

The assessment in recent weeks of the Average Directional Index (ADX) seen above on the S&P 500 (SPX) chart, HAS BEEN that of a weak trend or an intermediate-term 'non-trending' market, but this may now be changing. The ADX has been good in the past for showing when a short to intermediate trend, either UP or DOWN, begins. Given the recent strong upside recovery move AND the long-term trend consideration seen next, I think that the major indexes could move higher for still longer. Stay tuned on that!!

If you want to assess the intermediate trend direction with an 'objective' statistical model, the ADX indicator can be useful. This model does 'lag' the actual initial directional changes, as is the case with other models of this type or moving averages and so on. [The 14 'length' setting is the typical default setting for this indicator that you'll see and I don't change from it when I use this indicator and this 'length' setting is close enough to my preferred '13' setting, a fibonacci number.]

A TECHNICAL LOOK AT THE LONG-TERM TREND:

If we look at the long-term, multiyear, up trendline for SPX, it has held that line based on my current assessment of where that trendline intersects. Recent lows have to date also held ABOVE its (2006) prior low. This suggests to me that the LONG-TERM uptrend could still be intact and this then feeds into my thinking about how the extremes of BEARISH sentiment may be suggesting we're set for a recovery, especially one with greater strength and duration than the short-lived rallies seen in recent weeks.

Moreover, a long-term oversold assessment based on the 13-week Relative Strength Index (RSI) seen above is another aspect to the current technical picture. This market might not have a major move higher but the long-term oversold condition does suggest that the market may not decline further than already seen. We'll see what earnings season brings, but market participants may focus the most on 'the worst is behind us' and looking ahead to the effects of stimulus moves and rate cuts already made.

QUESTIONS/COMMENTS:
Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

GOOD TRADING SUCCESS!
 

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