Thursday, May 23, 2013

Wednesday Is a Key Reversal Day - Top Warning

Click on Chart to Enlarge

This chart is the Nasdaq 100, QQQ, and is a daily chart of prices.  Wednesday the stock indexes formed wide ranging bearish engulfing patterns which is a top reversal candlestick pattern where the price gaps up and then closes back below the opening price of the prior day.

In this case there was considerable range expansion with a higher high and a lower low in addition to a substantially lower close.  So this also forms a traditional "key reversal" day in bar chart terms.  Given the technically extended nature of this rally, the length of the rally being longer than median historical legs up, extreme "smart money" commercial futures short position, and multiple signs of historically surging "dumb money" into stocks of late, I think we need to pay special attention to this reversal and any possible subsequent failed breakout above it.

The gap up from 5/3/13 would be a first target on a continued decline from these levels.  A move down to fill that gap would make the current decline larger than any decline in this uptrend since November, so that would warn of a larger correction being in force. reports that over the last few sessions the ratio of bullish to bearish funds in Rydex funds has risen to historical extremes and that total leveraged bullish funds are greater than 6 times the amount of bearish funds.  The Nasdaq and Russell 2000 bullish funds are 14 times greater than bearish funds.  This is significant in that from 2007 to 2010 the ratio had run around 1-2, with occasional spikes to the 6-10 level at  significant market peaks in the 2011 to 2013 time frame.  But now we see a big surge higher which is clearly a dumb money surge into stocks now that the indexes are basically at new highs.

At highs it will feel like the market is likely to continue to rise and the lay person and average investor who has been on the sidelines will now be overpowered emotionally and finally act on putting money into the markets if they had been unsure before.  If you think about someone considering whether or not to put funds in the market, and not really following a systematic strategy, what is it that separates the moment of action from the long period of consideration and inaction before it??  It is an emotionally driven trigger that reaches a threshold and spurs one into action.  But unfortunately it is very untimely for the typical investor.

So time will tell what significance this current level holds in the markets, but one of my main goals in this blog has always been to highlight times when it is wise to take protective action or sell stocks.  In my experience both with my own development as a trader and working with other traders, it is not that difficult to find decent to good entry/buy points in stocks.  And most investors really only think deeply on the buy side.  But understanding when to sell, take profits, or rotate portfolio funds into a protective asset, are much more difficult for investors.

Much of this has to do with the different nature of market tops and bottoms.  The emotional nature of tops is often a drawn out complacency that leads to churning  action and lengthy periods of low volatility.  But at bottoms, brief periods of high volatility, spike lows, or spike followed by sharp retests are the norm, which may make them more recognizable and precisely timed.

So to be clear, I view this as one time where risk is high for a decline in stocks.  For some that may mean to look for short trading set-ups.  For others it may mean to take action, or partial action, NOW on stock investments rather than waiting for the eventual price movement lower to convince you.

The price move up since the mid April 2013 low has been dramatic, especially if you compare it to the average volatility during the period, or even the peak volatility on April 18th.  It has obviously brought the dumb money in, and in the face of persistently historic short positions by commercial stock index futures traders.  When the dumb money public is pouring it into the markets, and the most informed hedgers in the world are shorting the heck out of it, is NOT the time when you want to be buying stocks in for sure.  You either want to be getting out (possibly "early") or have a concrete exit or rotation strategy in place.

This chart shows the VIX (implied volatility index).  It typically falls as the market rises but at major turns it will tend to not confirm the price movement in stocks.  Currently we are seeing such a non-confirmation, and on a large scale.  Volatility has not moved below its March trough despite broad strength in stocks and extreme vertical price movement to new all time highs over the last 5 weeks.  The divergence is both sharp and of long duration compared to other such patterns at the highs of recent legs up in stocks.  Basically all tops of legs up going back to 2010 have displayed at least a minor non-confirmation pattern between the VIX and stocks.  So the current VIX pattern is typical of a topping market, and the size and angle of the divergence suggests to me that we could see a sharp rise in volatility as this high in stocks completes.

This is just an added evidence to help understand the underlying market sentiment.

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