S&P, VIX, and Shanghai Dow

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Since the market made higher highs, I think the best way to view the pattern in the S&P is in the last leg up of a triangle pattern. It is following pretty close the green projection line from this prior post. I am certain that many traditional Elliott wavers view what I have labeled as C, D, and E? as and ABC or a W-x-Y-x-Z up from the March low. In any case, I think the Elliott wave experts generally agree that a major top is close at hand.

From the "looks" of it, I would say the market will probably push modestly higher for a couple weeks. However, from a technical and sentiment perspective, I believe the stage is already set. It is just a matter of seeing a larger, faster correction than any during this advance since March to confirm that a larger degree top is in place.

DMI and Aaroon show reasonably strong trends in place, but basically every single daily oscillator is blaringly divergent on this move to new highs. Coupled with the post crash high at 1044ish and a doji in the cash S&P index today, it certainly would not surprise me if the market makes no further head way from here.

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The chart above is the VIX. Many will note the divergence in the VIX not making new lows as the indexes make higher highs. That has occurred several times on this rally, without meaning too mcuh. Although it does look different this time in that the VIX is basing at the 25 level rather than trending down or making quick sharp spikes up. The green lines indicate the wedge that many are watching to indicate a possible breakout to the upside in volatility.

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The is the Shanghai (Chinese market) Dow. I show this simply for the fact that it has been leading our indexes at tops and bottoms for more than a year, and also because based on some historical comparison to our market, what happened here might be what we should expect in our market.

In July our market shot way up and trended extremely tightly for a few weeks. The precedents similar to that kind of complete lack of mean reversion for that long, basically showed markets that were able to continue higher for several weeks, but then had most or all of the gains of that trend erased in sharp corrections. In the case of the Chinese market right now, this played out as well. All the gains from early June to early August were wiped out in about 2 and a half weeks.

In sum, as it stands now for longer term traders, I would be looking for entry any time on bearish trades. If you are holding bullish positions, then I would definitely suggest having stops in at last week's lows and also consider trailing them in some fashion if the market does move higher in coming days.

For shorter term (swing style) traders (excluding day traders), I would either avoid any new bullish trades, or only enter if there is a pullback this week that holds above last week's lows. And use those lows as a stop. For the top pickers (myself included) I would jump on any classic top reversal candlestick patterns with stops above the high of the pattern.

Hanging Man and Dragon Fly Doji

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All the notes are on the charts. All three major index ETF's showed textbook reversal candlesticks today. They are not the "strongest" of reversal candlesticks, but taken together with chart based resistance and overbought indicators, they should be paid attention to. In order to get some confirmation it is nice to see a gap down and a close below the open tomorrow. In fact, if there is no lower close tomorrow, then those tricky bulls probably took one of their guys and dressed him up in a bear's suit to act as a decoy.

The Russell ETF, IWM, also showed a somewhat odd Bearish Belt Hold today. It gapped up and sold off immediately and closed almost unchanged from yesterday, but down slightly. The gap being sizeable and the lower close should give weight to this pattern, but there is also a signifcant lower shadow, which is not really part of the classic pattern. I don't know that I've ever read anything in regards to how significant that shadow is on a belt hold pattern. In any case, that pattern is not more than medium reliability. However, the Russell has not made new highs for the rally, so there is still some measure on non-confirmation in the indexes this point.

Doji Candlestick Friday in the Dow and Nasdaq

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Friday marked what I think is the first really solid candlestick reversal pattern since the March lows. The Dow ($INDU) and Nasdaq ($COMPQ) showed doji candlesticks when it was all said and done. Regular blog readers may recall the March 8th post I made about doji patterns as the market formed a bottoming doji the previous trading day. A classic reversal pattern in the context of an overbought and overly optimistic market will typically make for good trade. For confirmation, we would want to see a down day tomorrow (Monday), with a secondary scenario as another very small range day (like another doji) tomorrow followed by a downer Tuesday.

Click on the chart above to read the other notes on the chart. But the take home message is that Friday was a very narrow range day compared to recent ranges over the last few months. From a historical perspective, this type of set-up has led to a negative return over the next 2 days about 60% of the time. Also, these narrow range days have shown up with relative frequency at important tops in recent months.

Also, last week I mentioned the Smart Money and Dumb Money confidence indicators from Sentimentrader.com and how it was showing that the Dumb Money was showing an extreme confidence reading that has typically occured within a couple days of major down turns in this bear market. As of Friday's close the Dumb Money confidence reading was the same, but the Smart Money confidence dropped to a lower level than any other in this bear market. This has caused the spread between the Dumb and Smart money to widen to a level that has been very good at identifying market turns.

This past week the ratio of puts to calls that were bought to open by small traders (1 to 10 contracts -- and typically good to bet against) dropped to its lowest level in months. The current levels were last seen in late September 2008 and in June 2008.

While my hammering home of the bearish case may be monotonous by now, it is important to know that the current sentiment environment has consistently led to declines in this bear market, so if we don't see that begin to happen this week, then we better be more cautious with bearish trades because things will be out of the ordinary.

On the trade management front, my hope is to get immediate downside this week and move in a stop on the BGZ trade corresponding to last week's highs which would make any potential loss a small one. Then when the next oversold signal comes, I will evaluate whether to continue to hold or not.


Pete

Doji Candlestick in Major Indexes Friday

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The chart above is the cash S&P 500, ticker $SPX. On Friday the major stock indexes gapped up slightly and then put in a strong first hour advance adding about 2%. After that, prices fell about 4% going about 2% lower than Thursday's close. Then in the last hour of the day, prices advanced about 2.5% to close the day almost unchanged from Thursday or from the open Friday.

The end result of this price action is called a "doji" candlestick pattern, and more specifically a "long-legged doji." A doji candlestick is one where the open and close are almost the same, so that the fat part of the candlestick just looks like a little crossways hash mark. When a doji occurs after a long downtrend (or uptrend), it shows that the market is in temporary perfect balance. I think of it as a ball in freefall. Then as the ball hits the ground, there is an instantaneous moment where the ball is perfectly motionless before being propelled upward by a strong reactionary force from the ground.

The doji is a fairly reliable candlestick reversal pattern in and of itself. However, if the following day is a strong day in the opposite direction of the prevailing trend, then the pattern is even more reliable. So Monday will give us a lot more information in this regard. There are other more subtle/detailed factors to look for that will give you additional information on the strength of the pattern. Here are some of the factors to look for:

1. the higher the volume, the more reliable the pattern typically
2. oversold technical indicators will help to assure market is at an extreme
3. pattern occurring outside bollinger bands should be more reliable since price is at a statistical extreme
4. pattern occurring inside the bollinger bands when prices have recently been outside the bands may be even stronger as it is a sign the current trend is weakening
5. when looking at a potential bullish reversal pattern, it is best if price closes in the center of the range (high to low) or higher
6. extreme sentiment readings help assure a market is primed for a reversal from a psychological perspective

In sum, Friday's action is suggestive of a strong reversal within the next couple days in my opinion. A large up day on Monday will give added confirmation of that outlook.