MAILBAG QUESTION:

"How do you see the market now since it finally stumbled after such a long run up. I think stocks have got to come down more. what do you think?"

MY RESPONSE:

I spent some time this Memorial Day reflecting on how brave are our soldiers, sailors and airmen that they risk, and lose, their lives in combat. Thanks to them all!

Frankly, it's hard to look at this strong long-term stock market trend and think prices are going to come off much at all. Nevertheless, I have found over the years a reliable price and indicator pattern that fits a significant top; i.e., a top that will be followed by more than just a relatively small and brief dip. There are three things that often or most often occur in close proximity related to trend reversals:

1.) PRICE ACTION

2.) OVERBOUGHT/OVERSOLD EXTREMES

3.) 'EXTREMES' IN BULLISH BEARISH SENTIMENT

I'll take each of these 3 pattern aspects separately.

Price Action:

In terms of price patterns that suggest that significant technical resistance has been reached implies one of two things typically. The major indexes or 1-2 of them hit a prior key resistance and top and start coming under selling pressure. At new highs for a multiyear period, a prior top may not be seen; or, there's a major top from years back that's still a long way off like the Nasdaq.

A prior key 'resistance' could also be a trendline that acts as resistance. The most notable example is seen with trendline price channels where the upper channel line is anticipated to 'act as' resistance and a likely area where a top, temporary or otherwise, may form.

A good example is provided by this snapshot of the weekly S&P 500 (SPX), which has an upper channel line that intersects in the 1750 area. There's no prior top from months or years past to focus in on as offering potential resistance. The upper channel line does provide a concept of how high SPX could go before potential resistance currently.

Note that SPX has gotten to an extreme in terms of a high Relative Strength Index (RSI) reading seen above at what is typically been an overbought extreme. The problem with such an indicator reading alone is that in past instances of either overbought or oversold extremes (highlighted by the red down and green up arrows) is that AFTER such extremes were seen it was sometimes 6-10 weeks later that prices made a final high or low. Although as you can see in the chart above, prices didn't go a lot higher or lower.

OTHER than hitting a prior high and possible resistance, or a resistance trendline, there are other trend REVERSAL patterns. Namely, key downside or upside reversals form from time to time. A downside reversal for example is simply the pattern of a new high, followed by a Close that's under the prior 1-2 days closing levels. What I call a KEY downside reversal is where prices go to a new high, often a decisive new intraday high, followed by a collapse in prices that takes a major index to a Close that's below the prior Low of the past 1-2 days. This type of reversal pattern is rare and after prolonged advance is quite predictive for at least an interim top if not at times a 'final' top.

Price AND 2 key Indicators considered together:

When such downside price reversals occur in conjunction with extreme readings in the 13-day or 13-week RSI AND in the case of TOPS, where bullish sentiment gets to what I consider to be an 'overbought' extreme, these three events occurring within close proximity (e.g., within 3-5 days of each other), is highly predictive of a significant TOP.

In terms of my trader 'sentiment' indicator seen above, the peak readings on the upside are when CBOE daily equities call volume gets to or near twice that of daily equities put volume. A high reading in my CPRATIO model is on the upper end of the scale, making it 'read' the same way as an overbought extreme at the high end of the RSI scale. Put to call ratios read the other way; e.g., a reading of .5 is where put volume is half that of call volume and is of course the same as call volume being 2 times put volume. I prefer to work with whole numbers and divide calls BY puts and not the reverse. Whatever works for ya!

Wave theory offers some guidelines to how far a downside correction might carry. An correction pattern often takes the form of a down-up-down or 'a-b-c' pattern. The first downswing is measured from intraday top to intraday low. Once you can see that a rebound is under way, then you know how far the first decline has carried.

As an example, a first decline (to point 'a') carries SPX lower by 100 points, a subsequent rebound (to point 'b') carries the index back up 35-50 points. A second decline (to point 'c') then sets in that will typically carry FARTHER than the first sell off, often by a factor of a Fibonacci 1.5 to 1.6.

An example highlighted below shows the shape of an 'a-b-c' correction. I'm not predicting future highs or lows but just the pattern of a decline, followed by a minor rebound, followed by another, typically steeper, decline.


GOOD TRADING SUCCESS!