Review of Major Stock Indexes

Happy New Year! Leigh Stevens has "retired" and he wrote his last Index Wrap last weekend. I (Keene Little) will now write these Wraps and I have some big shoes to fill. For those of you who have been reading my Wednesday Market Wraps, the format of my reviews will be familiar. If there are some new/different things you'd like to see in the Index Wraps please be sure to provide some feedback. This weekend's Wrap will be longer than usual as I'll take a little extra digital ink to help explain what I look for on the charts. Future indexes will be shorter since I know your time is important and it's often good to just get a quick review of the charts to see where we are and where we might be going.

The real Santa Claus rally is the week between Christmas and New Year's and into the first week of January. But Santa appears to have been abducted by the bears and it remains to be seen whether or not they'll release him unharmed in the coming week. Negotiations appear to have stalled until we get through the holidays.

The past week was a slow-volume period, as expected between the holiday breaks, and with a low-volume environment it's much easier to push the indexes around with a couple of buy and/or sell programs. For this reason it's typically a little more difficult to evaluate a move in a slow week as it relates to the larger pattern. The question facing us this weekend is whether Santa's no-show this past week is part of a "real" move or instead only a reflection of some strong bears taking advantage of the low volume.

The January barometer is in front of us, which states "As goes January, so goes the year" and it's also typical for the first week of January to set the tone for the rest of the month. Therefore we could say "As goes the first week of January, so goes the year." That turned out to be true for 2015. But it was not true for 2014, which started off with a negative first week but finished as a strong year for the bulls. As with all "typical" or seasonal patterns, they might give you an idea for what to expect from the market but it's the daily/weekly review of the charts that is much more important. The "typical" patterns for the market have typically not worked in the past year and that is more likely than not to continue.

As I'll review in the charts, last week's decline might have been the start to something more bearish, which is the way I thought it was setting up for, but the first week will provide stronger clues. While it has been my opinion 2016 will be one for the bears, which should start with a negative first week in January, it's very important to follow the charts and not a personal opinion (mine or anyone else's). We all trade with a bias but holding a bias too long is what gets traders into trouble. With that let's see what the charts are telling us and what levels should change our opinion.

[My charts will show "key" levels where a price pattern either turns more bullish (above the green target symbol) or more bearish (below the red target symbol). Support and resistance levels will be pointed out on the charts. I like to show one weekly chart, typically for the S&P 500, to give us a broader view of the "market" and to help give us a longer-term sense of market direction.]

A Look At the Charts

S&P 500, SPX, Weekly chart

While I feel there is a good change the market has topped, which makes the market vulnerable to a surprise attack by the bears, I keep looking for evidence for why I'm wrong. At the moment there is insufficient evidence in the price pattern to confirm a top is in place and therefore I'll continue to respect upside potential while warning of downside risk (it is my opinion downside risk dwarfs upside potential).

Because of all the choppy price action since the August low I think there's still a chance we could see the market chop its way higher inside what I believe would be a rising wedge. In EW (Elliott Wave) terminology it would fit as an ending diagonal 5th wave to complete the rally leg from October 2011, which in turn would complete a large A-B-C leg up from 2009 (as part of a larger bear market pattern). This is just an idea to explain how a choppy rally could continue up to about 2200 into April but at the moment there is a potential bearish pattern that says we've already seen the top and that we're due a strong sharp decline from here, one that could take SPX down to the 1970 area in the coming week and then lower later in January. A drop below the December 16th low, near 1993, would trigger the more bearish potential while a rally above the November 3rd high near 2117 is needed to keep the bullish pattern alive.

S&P 500, SPX, Daily chart

The daily chart below shows a decline to SPX 1970 would be a test of the bottom of its parallel down-channel for the decline from the November 3rd high. If that decline happens in the coming week it would be 109 points from last Tuesday's high at 2081. Thursday's close near 2044 was a decline of 37 points, leaving 72 to go. That's not unreasonable considering the large whippy moves we've been seeing. It's also not unreasonable when you realize January 2014 and January 2015 both saw declines of 101 and 110 points, respectively. But in January 2014 it was the last half of the month and in January 2015 it was the first week.

The first bullish sign would be a rally above last Tuesday's high at 2081 and then confirmed more bullish above price-level S/R near 2090. There is a lot of overhead resistance and therefore any long plays will need to be tightly managed. For the short side, the first support level for SPX is its uptrend line from September-December, currently near 2024, and then down near price-level S/R near 1993. Closing back below its 20-, 50- and 200-dmas is another bearish sign for an end-of-week/month/year close so if the bulls are to pull another rabbit out of the hat, they need to do it quickly on Monday.

From an EW perspective it's important to note that the bearish wave count is very bearish -- a series of 1st and 2nd waves to the downside following the November 3rd high, which calls for a powerful move down in a series of 3rd waves. It would be the kind of move that will break below the August low before the end of January. This is the reason why I say downside potential far exceeds upside potential and until I see the bearish pattern negated I would stay more defensive than offensive (unless offensive to you means in bearish plays). If you like playing the short side, which is difficult but has the potential to make more money faster, last week's setup into the top of the parallel down-channel made a nice entry point. Bounces are to be shorted until the bulls prove the bears wrong, starting with a rally above last Tuesday's high at 2081.56.

S&P 100, OEX, Daily chart

OEX has virtually the same pattern as SPX with only minor variations and therefore has the same setup. The choppy pattern for the decline off the November 3rd high is the very definition of a downtrend with its series of lower highs and lower lows (within a down-channel). But because of the overlapping highs and lows it could easily be interpreted as a corrective pullback in a bull flag pattern.

There is a bullish pattern that projects to 958 for the 5th wave in the rally from August but this pattern does not fit well on several indexes, which is a reason to doubt it. But a rally above the December 2nd high at 938 would trigger the more bullish pattern and a rally above last Tuesday's high at 929 would provide a bullish heads up. The high near 929 is also a good stop level for any short positions unless you're using them for hedging your long positions. The pullback on Thursday/Friday had the OEX coming back down to its 200-dma, near 910, and therefore the bullish setup here is for a back-test to be followed by a bullish kiss goodbye.

Price action since November's high has been a choppy whippy mess and traders on both sides have likely felt like they're banging their heads against the walls on both sides of the room. That could continue and it's the reason for caution here. See where support and resistance are and watch for reversals to trade but then get defensive in the position. Let price tell us when a directional trade should have better luck in continuing that direction (starting with a move above or below the key levels).

Dow Industrials, INDU, Daily chart

The DOW has formed a pattern that is between a pennant (sideways triangle) and a bull flag, either of which are bullish continuation patterns when they follow a rally. This is a bullish pattern that bears need to respect. The DOW pulled back last week to its uptrend line from August-September, which had been broken for only a day on December 18th. A second break would be more bearish and it would likely lead to another drop to the bottom of its pennant/flag, near 17060.

As mentioned earlier, the bulls need to step back in immediately if they want to keep this from turning at least short-term bearish. If the DOW does drop down to the bottom of its pattern it would be the next opportunity for bulls to turn this bullish continuation pattern into a new rally leg. But if the bullish pattern is followed by a breakdown instead it would likely lead to a strong decline (failed patterns tend to fail hard). The bearish wave count calls for multiple 3rd waves to the downside, which is a reason why the bullish pattern could fail.

Nasdaq Composite, COMPQ, Daily chart

The pattern off the November high for the Nasdaq can be viewed the same as the blue chips (half pennant, half bull flag) but a slightly different bullish interpretation is shown on its chart below -- it could be finishing the last leg of its rally in a small rising wedge (ending diagonal 5th wave) for the leg up from December 14th. This calls for one more leg up to potentially finish the wave count and it would likely finish near the previous highs in November and December, which would create a bearish triple top if it occurs. But even the short-term bullish pattern would be negated if the Nasdaq drops below its December 18th high near 4921. At the moment the lower highs for the oscillators since November favors the bears.

Nasdaq-100, NDX, Daily chart

NDX has been in a sideways trading range since November and it takes a break out of the relatively wide range between 4475 (which includes the 200-dma) and 4740 before we'll have a better sense of direction. As with the Nasdaq, I see the potential for another leg up to complete a small rising wedge pattern and another test of the top of the trading range. It could drop to the bottom of the range and then start a new rally leg but if it breaks below 4475 I believe we'll see a flush to the downside.

Russell-2000, RUT, Daily chart

The RUT has continued with a different (weaker) pattern than the others and looks more bearish. Following the impulsive December 2-14 decline we've seen a 3-wave corrective bounce into last Tuesday's high. The pullback into Friday's low is sitting on the short-term uptrend line from December 14-21 and once again, the bulls need to immediately step back in before a further drop turns it even more bearish. I see the potential for another leg up at least to price-level S/R near 1170 if the bulls can get some buyers behind their cause. But a drop below the December 18th low near 1120 would suggest a stronger selloff is in progress, in which case I'd expect to see the September low near 1080 broken in the next week or two.

The last two charts, for SPY and QQQ, bring volume studies into the mix. These two ETFs enable us to use volume more accurately than can be done on the indexes, especially since these two funds are among the heavier-volume ETFs and provide some good sentiment indications. In addition to straight volume at the bottom of the charts I also show the Money Flow Index (MFI) on the SPY chart and Williams %R on the QQQ chart. I also have the Bollinger Band (BB) on both charts.

For a review of these indicators, the MFI, also known as volume-weighted RSI, is an oscillator that uses both price and volume to measure buying and selling pressure. As a momentum oscillator that uses volume, the MFI is good at identifying reversals and price extremes. As with other oscillators, divergences between price highs/lows and MFI highs/lows can help identify reversal setups.

Williams %R is a momentum oscillator that looks just like the Fast Stochastic Oscillator but without the smoothing line. Rather than using the cross of the oscillator and its smoothing line, Williams %R is best used to show extremes and divergences. The caution is that, like stochastics, it can remain overbought and oversold in a strong trend. This is particularly true for rallies. Bottoms tend to be more of the v-reversal variety and an oversold Williams %R can be a good warning sign.

The Bollinger Band (BB) shows a 2-standard deviation channel from the 20-moving average. Typically, when price moves two standard deviations away from the 20-dma it shows an extreme move based on recent price action (the channel will narrow during low-volatility periods and expand during high-volatility periods) and a reversal from that extreme often identifies where and when price is likely to move back at least to the 20-dma (center of the band).

As with all technical indicators, they're best used with other indicators in an attempt to get corroboration between the trading signals. The Bollinger Bands on the SPY and QQQ charts help identify price extremes. When price pokes out the top or bottom of the band and then closes back inside the band it's generally a good reversal signal following the momentum spike. Combining that with the signals you get with the oscillators and volume helps better identify the reversals.

SPDR S&P 500 Trust, SPY, Daily chart

On the SPY daily chart below you can see how it poked through the bottom of its BB twice in mid-December. Both times saw higher-than-normal volume and the MFI dropped into oversold territory. The first bounce off the December 18th low made it only slightly above the 20-dma, as did the bounce into last Tuesday's high, before reversing right back down. And before those two bounces was the December 2nd high, which also failed to make it up to the top of the BB, a sign of weakness in the rally (compare the last three rally attempts in December to the rallies off the August and September lows). But the lower price low on December 18th was met with a higher low for MFI, which showed us bullish divergence. If we get another price low with another bullish divergence I would be very careful about the downside and instead look for a buying opportunity, especially if a decline holds at the bottom of the BB and does not penetrate the bottom of its flag pattern, currently near 198.75.

Powershares QQQ Trust, QQQ, Daily chart

Similar to SPY, we saw two jabs below the bottom of the BB for QQQ in mid-December and Williams %R showed bullish divergence on the second penetration. Volume at each low was slightly higher than normal and Williams %R spiked into oversold each time, which provided a warning about a reversal. Last week we saw an attempt to rally back above the 20-dma, again, but it failed to reach its upper BB before Williams %R hit overbought and reversed back down last Wednesday. At the moment it's looking like it will drop back down to the lower BB and the bottom of its sideways trading range, near 109.40. A drop below that level without volume spiking higher and/or Williams %R not dropping into oversold would be reason enough to stay on the short side. But as discussed above, the sideways trading range is a bullish continuation pattern and therefore we could get another buy setup with a drop down to the bottom of its range if we get some corroborating evidence from the indicators.

Good luck with your trading in the coming week and I'll be back with you next weekend.

Keene H. Little, CMT

Technicians look ahead. Fundamentalists look backward. The true language of the market is technical. - Joe Granville