Weekly Technical Market Outlook 10/13/2014

Well it seems the warning flags that the market internals (momentum and breadth) had been showing us were correct. Back on September 22nd I wrote “I think right now the U.S. equity market is showing some negative symptoms. This doesn’t mean we need to call the morgue but there seems to be something happening based on the internals and the information price action is providing us.” Since then we’ve seen price fall 5%. Now, based on your personal investment time frame that 5% could be irrelevant or the volatility you needed to add some alpha.

Trend

For quite a while the trend portion of my Weekly Technical Market Outlook had been pretty self-explanatory. With this recent period of volatility some major levels of support have been broken. The 100-day Moving Average and rising trend line that had keeping investors bullish have now been put in price’s rear view mirror.

The S&P 500 ($SPX) now sits just a few hairs above its August low as well as the 200-day Moving Average (not shown). A meaningful drop here would create a lower low and potentially signal the end to the current up trend. I say meaningful because I’ll be looking for price to get lower than just 1897, but closer to 1880 to gain confidence that the bears are truly in control and the trend has changed, but that’s just me.

trendTreasury Bonds

As traders have left the warm familiarity of stocks and shifted to bonds, the varies portions of the Treasury yield curve has rising steadily. The more-often discussed Treasury 20+ Year ETF ($TLT) has already exceeded its prior high but today to focus on the shorter-term Treasury 3-7 Year ETF ($IEI). This Treasury ETF held sold support in the Relative Strength Index (RSI) just a few points under 50 while it pushed against its rising trend to make a run for its 2013 high. Price now sits right at that early ’13 peak along with its momentum indicator ready to break its own level of resistance.

IEIBreadth

The following chart was one of the signs we had that trouble may have been brewing for stocks. The Advance-Decline Line failed to make a new high along with price, creating a bearish divergence. While the S&P 500 sits right at its prior low, this measure of breadth has broken its own August low and now finds itself back at a level not since seen April of this year.

Meanwhile, the Percentage of Stocks Above Their 200-day Moving Average has dropped down to its December 2011 level with fewer and fewer stocks able to keep their heads above their proverbial trend water line.

breadthCotton

Back in August I wrote a piece for See It Market looking at the potentially bullish setup in price, sentiment, and COT data for Cotton ($BAL). Since then we have not seen cotton prices move very much, as they began to rise only to weaken once again and put in a slightly lower low. However with this recent low we now have a bullish divergence in the Relative Strength Index (RSI) on the weekly chart as it did not confirm the move lower. Looking at price, it appears we may have a false breakdown under the 2012 low, I’ll be watching to see if $BAL can stay above this level going forward. When checking back in with the COT data since August, Commercial Traders have continued to add to their net-long position. They are now holding their largest net-long position in at least 4 years!

While cotton prices haven’t shot higher since my last writing on the commodity, the bullish case for higher prices in cotton continues to hold true in my opinion.

CottonMomentum

Like the Advance-Decline Line for breadth, the RSI and MACD momentum indicators were flashing warning signs back in September as they were unable to confirm the new high. We now have the RSI sitting right at its support level. Will we get a bounce or will momentum move to an ‘oversold’ level before the bulls get any reprieve.

momentumS&P 500 Bollinger Bands

As anyone who has been around the markets for any extended period of time can attest to, oversold markets can always become MORE oversold. And this is also true when it comes to the use of Bollinger Bands, and is something I want to point out before diving into this next chart.

Below is the S&P 500 along with a set of Bollinger Bands. Typically these bands use a 20-period Moving Average with the outside bands set at 2 standard deviations. But one set of Bands that I watch uses the 65-day MA and a 2.5 standard deviation. I’ve noticed that we see prices put in a low when they reach this lower Bollinger Band. In the bottom panel of the chart is the %B indicator, which simply shows where price is in relation to the Bands. As you can see, when price has previously reached its lower Band, a low is often put in or not too far away. The obvious exception from the last six years was the 2008 bear market.

The drops that we’ve seen in the S&P 500 each year (excluding 2013 since we didn’t see any material decline) seems to have come to an end at the lower band of this set of Bollinger Bands, will this decline be different?

spx bb

Emerging Markets

Martin Pring, who wrote Introduction to Technical Analysis and developed many different indicators created a Diffusion Indicator to be used with different markets. Pring’s Diffusion Indicator looks at the number of stocks within a given market and how many are above their 40-day Moving Average. Pring then takes a 10-day Moving Average, which is what’s plotted below for the Emerging Market Index.

As the chart shows, when this indicator has gotten down to -12 over the last several years it’s signaled a bottom for the iShares Emerging Market ETF ($EEM). This is a helpful tool I use to help find potential short-term turning points within certain markets. I’ll be watching to see if this low in the Pring Diffusion Indicator helps put in a low for $EEM.

EEMLast Week’s Sector Performance

With little surprise the strongest sectors last week were the three defensive portions of the market, Utilities ($XLU), Consumer Staples ($XLP), and Health Care ($XLV). While stocks bled for most of the week, Utilities and Staples actually closed out on Friday in the green. Energy ($XLE), Industrials ($XLI) and Materials ($XLB) took the brunt of the damage.

last week sector

Year-to-Date Sector Performance

With Utilities recent strength it has moved back to the top spot for 2014. Close behind is the Health Care sector, followed by Consumer Staples and Technology ($XLK). The Energy sector remains the worst performing part of the market YTD followed by Consumer Discretionary ($XLY).

Based on the Sector Rotation Model at stockcharts.com, it’s a bit concerning to see Utilities, Health Care, Staples, and to a lesser degree Financials, leading the way so far this year, as those four sectors sit at the top of the economic cycle. Much more digging would need to go into this type of analysis but I believe it’s an important note to make.

ytd sector

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

Will This Historically Bullish Setup Send Stocks Higher?

While stocks finished trading on Wednesday higher by 1.75%, we still saw an increase in the number of stocks making new 52-week lows on the NYSE. At first glance I thought this was another sign of deteriorating breadth, with fewer stocks participating in the advance. Not to say this is not true or to take away from the notion that breadth has been weakening over the last several weeks, but historically this setup has been short-term bullish for equities.

To look at things further I put the data in excel and ran the numbers. Below is a chart that shows past instances of the number of new 52-week lows on the NYSE rising, the S&P 500 ($SPX) closing with a gain of at least 0.80%, and the percentage of NYSE issues making a new 52-week low being greater than 7% going back to 1990. It’s rather common for the number of new 52-week lows to increase while stocks rise, but it’s rather rare to see this occur with a large percentage of stocks.

As you can see, when these three criteria are met, we have historically had a short-term bottom in stocks. The last example of this happening was in 2011 and before that was at the 2009 low. When looking at the data it’s hard to ignore the instances where these measures lined up before the 2000 and 2007 highs. So it is not to say that we won’t have lower prices, as there are many pieces of data right now that could help make that argument. However, we may be seeing some exhaustive selling that could allow equity bulls some reprieve.

If we were to tighten up the criteria to the S&P 500 having a gain of greater than 1.75%, like we saw on Wednesday then the number of previous occurrences gets cut from 24 down to 7, with the last four occasions being March 3, 2009, September 2008, and October 1999.

Indicator

Data courtesy of stockcharts.com

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

Head & Shoulders Pattern in Small Caps

There seems to be a lot of discussion about the current bearish pattern that’s taking place in the Russell 2000 ($IWM). While there are likely tens if not hundreds of price patterns found throughout technical analysis, few are as popular or often discussed as the Head & Shoulders pattern. There is good reason for is this as it has lead to some major declines in financial markets. For example there was a Head & Shoulders pattern that lead to the peak in the Dow back in 2007.

Should we be concerned about this bearish pattern? Does it hold any relevance? One good resource is thepatternsite.com, which does a great job looking at the data of varies candlestick and price patterns. According to Bulkowski’s analysis, the Head & Shoulder pattern ranks number 1 among 21 well-known pricing patterns. This is based on the 4% failure rate and 22% average decline calculated by Thomas Bulkowski.

So it appears we may have good reason to take these types of setups seriously, so what defines a Head & Shoulders top? There are few better resources to turn to than Robert Edwards and John Magee’s, Technical Analysis of Stock Trends – often considered the bible of Technical Analysis. Edwards and Magee seem to agree with Bulkowski stating in their book, “This [the Head & Shoulders] is one of the more common, and by all odds, the most reliable of the major Reversal Patterns.”

They continue in their writing to define what they believe is the “ideal” Head & Shoulders top:

A. A strong rally, climaxing a more or less extensive advance, on which trading volume becomes very heavy.

B. Another high-volume advance which reaches a higher level than the top of the left shoulder, and then another reaction on less volume which takes price down to somewhere near the bottom level of the preceding recession.

C. A third rally, but this time on decidedly less volume than accompanied the formation of either the left shoulder or the head, which falls to reach the high of the head before another decline sets in.

D. Finally, decline of price in this third recession down through a line (the “neckline”) drawn across the Bottoms of the reactions between the left shoulder and head, and the head and right shoulder, respectively and a close below that line by an amount approximately equivalent to 3% of the stock’s market price. This it he “confirmation” or “breakout.”

We now know what we are looking for with respect to the bearish reversal pattern in $IWM. Now lets see if the latest price action meets the above mentioned criteria. Below is a daily chart of the iShares Russell 2000 ETF ($IWM). I’ve marked the two shoulders and the head as well as the horizontal neckline at $108.

In the bottom panel we can see that volume has been declining with the formation of the head and right shoulder. Based on the work done by Edwards and Magee, we would need to see a breakdown to roughly $104.76, which would be 3% under the neckline. Volume on the break can also be an important ‘tell’ as bears will be looking for a strong move on heavy volume to help confirm and complete the pattern.

IWMWith this type of pattern we can calculate the expected measured move by looking at the distance from the head of the pattern to the neckline. This would take us nearly 10% low down to $98. However, it’s important to note as Bulkowski stated, only 55% of the patterns actually complete their expected measured move.

While these types of patterns garner much attention nothing matters until the neckline is broken, which Edwards and Magee point out that roughly 20% of necklines are “saved,” meaning the pattern is not 100% completed. Going forward I’ll be watching the $108 level and see if we get a break on heavily volume and if price is able to drop to $104 to confirm the move is not in fact a false breakdown. But until then we must be a patient.

Source: Technical Analysis of Stock Trends by Robert D. Edwards and John Magee (ninth edition)
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.