Trading

It seems like there is a mighty long fuse on the real economic recovery.  We might be in for a longer wait than the recent rally led some to believe.

A record drop in pending home sales and a slowdown in the construction
market contributed to a sluggish outlook for the economy last week, and highlighting the significance of government stimulus measures and job
growth.

Market Commentary

The Nasdaq Composite Index is showing a well-formed Head and Shoulders topping pattern.  Price has broken beneath the neckline, which means it has triggered.  Unless it can move back above that level, the pattern's target is the distance from the top of the head (2500) to the neckline (2100), which is 400 points lower.

Supporting the bearish case, new 52-week lows are expanding on the Nasdaq while new 52-week highs are drying up. Net New Highs (new 52-week highs less new 52-week lows) is an easy way to assess the battle for new 52-week extremes. An uptrend is unlikely as long as Net New Highs remain
negative.

Technical Analysis is often easy to see after the fact.  Here is a look at several Head and Shoulder top and bottom patterns.  Click the image to see a bigger version.

Here's Something That Will Show-Up On Lots of Radar Screens.

On some level, Technical Analysis is a self-fulfilling prophecy because "everyone" is looking at the same thing.  While lots of people are worried about the Head and Shoulders pattern, I suspect that far more are watching the "Death Cross" or "Dark Cross" that is being formed on our indices as the 50-day moving average falls below the 200-day moving average.

While I see the bearish implications, some trader's will be looking for the head-and-shoulders and death-cross patterns to fail because of a short squeeze.  Failed patterns often result in bigger moves than the patterns that didn't work.  Here is an explanation about why that happens.

The OOPs Trade: 

When a well-known pattern fails, the response is often dynamic. This often happens with obvious, high profile situations like a "Head-and-Shoulders"
pattern, a move through big Round
Numbers (like Dow 10,000), crossing
the 200-Day Moving Average, or violating a clear Price Channel. Just for the record, several of those are in-play at this price level.

An often violent reversal happens when the crowd realizes that it was wrong, and people rush to cover their painful losing positions.  As the price of the stock increases, more short sellers feel driven to
cover their positions.  This is very similar to a short squeeze;
and the move is often violent and prolonged.

The markets are
oversold here; lots of people know that we just made new lows, and we
have been bombarded with bad news recently.  So, I'm not predicting that
the market will reverse here. I am just suggesting that it is
possible and something to watch.

It seems like there is a mighty long fuse on the real economic recovery.  We might be in for a longer wait than the recent rally led some to believe.

A record drop in pending home sales and a slowdown in the construction
market contributed to a sluggish outlook for the economy last week, and highlighting the significance of government stimulus measures and job
growth.

Market Commentary

The Nasdaq Composite Index is showing a well-formed Head and Shoulders topping pattern.  Price has broken beneath the neckline, which means it has triggered.  Unless it can move back above that level, the pattern's target is the distance from the top of the head (2500) to the neckline (2100), which is 400 points lower.

Supporting the bearish case, new 52-week lows are expanding on the Nasdaq while new 52-week highs are drying up. Net New Highs (new 52-week highs less new 52-week lows) is an easy way to assess the battle for new 52-week extremes. An uptrend is unlikely as long as Net New Highs remain
negative.

Technical Analysis is often easy to see after the fact.  Here is a look at several Head and Shoulder top and bottom patterns.  Click the image to see a bigger version.

Here's Something That Will Show-Up On Lots of Radar Screens.

On some level, Technical Analysis is a self-fulfilling prophecy because "everyone" is looking at the same thing.  While lots of people are worried about the Head and Shoulders pattern, I suspect that far more are watching the "Death Cross" or "Dark Cross" that is being formed on our indices as the 50-day moving average falls below the 200-day moving average.

While I see the bearish implications, some trader's will be looking for the head-and-shoulders and death-cross patterns to fail because of a short squeeze.  Failed patterns often result in bigger moves than the patterns that didn't work.  Here is an explanation about why that happens.

The OOPs Trade: 

When a well-known pattern fails, the response is often dynamic. This often happens with obvious, high profile situations like a "Head-and-Shoulders"
pattern, a move through big Round
Numbers (like Dow 10,000), crossing
the 200-Day Moving Average, or violating a clear Price Channel. Just for the record, several of those are in-play at this price level.

An often violent reversal happens when the crowd realizes that it was wrong, and people rush to cover their painful losing positions.  As the price of the stock increases, more short sellers feel driven to
cover their positions.  This is very similar to a short squeeze;
and the move is often violent and prolonged.

The markets are
oversold here; lots of people know that we just made new lows, and we
have been bombarded with bad news recently.  So, I'm not predicting that
the market will reverse here. I am just suggesting that it is
possible and something to watch.

The deficit, the war, and the oil spill are still in the news.  While this cartoon jokes about how America achieves greatness, I suspect it is a topic that will get more attention.

The Fed left rates unchanged, citing overseas threats and "developments abroad." Do you see that as a sign that cooperation is waning?  Likewise, despite seeking further stimulus at the G20 Meetings this week in Toronto, the US found that world leaders were more concerned with trimming deficits.

Meanwhile, US Treasury Secretary Timothy Geithner told the BBC that the US can 'no longer drive global growth'; and the world
"cannot depend as much on the US as it did in the past". Instead, he said that other major economies would have to grow more for the global economy to prosper.

With that in mind, there are three big bearish macroeconomic stories hanging over the market:

• The sovereign debt issue in Europe.
• The slowing Chinese economy.
• The second leg down in housing.

The big question is – to what extent is the bad news already priced-in to the market?

Let's Look at the Charts.

The markets moved lower, as the economic news from housing
to retail sales to revised Q1 GDP continues to confirm the weakness.

The weekly chart of the S&P 500 Index shows that we are still beneath the down-trend that started in late 2007.  While price has held above the 1040 support zone (marked by the green highlight), last week's pattern (marked by the orange circle) is considered bearish.  The week started higher, yet closed lower, than the prior week's range (this is called a Bearish Engulfing Pattern); and often signals a trend change.

However, short term oscillators are getting more oversold. As a result, there are probably lots of people looking for an oversold rally next week.

A Leading Indicator of Economic Activity is Dying-Up.

If you are looking for insight into global
supply and demand trends, the Baltic Dry
Index is one of the purest leading indicators of economic activity. It
offers a real-time glimpse at global raw material and
infrastructure demand,
as well as the supply of ships available to move this type of cargo.

Since making a short-term peak in late May (about a month after equity
markets peaked), the index has declined 38%, and
has just dropped below its February lows.

The deficit, the war, and the oil spill are still in the news.  While this cartoon jokes about how America achieves greatness, I suspect it is a topic that will get more attention.

The Fed left rates unchanged, citing overseas threats and "developments abroad." Do you see that as a sign that cooperation is waning?  Likewise, despite seeking further stimulus at the G20 Meetings this week in Toronto, the US found that world leaders were more concerned with trimming deficits.

Meanwhile, US Treasury Secretary Timothy Geithner told the BBC that the US can 'no longer drive global growth'; and the world
"cannot depend as much on the US as it did in the past". Instead, he said that other major economies would have to grow more for the global economy to prosper.

With that in mind, there are three big bearish macroeconomic stories hanging over the market:

• The sovereign debt issue in Europe.
• The slowing Chinese economy.
• The second leg down in housing.

The big question is – to what extent is the bad news already priced-in to the market?

Let's Look at the Charts.

The markets moved lower, as the economic news from housing
to retail sales to revised Q1 GDP continues to confirm the weakness.

The weekly chart of the S&P 500 Index shows that we are still beneath the down-trend that started in late 2007.  While price has held above the 1040 support zone (marked by the green highlight), last week's pattern (marked by the orange circle) is considered bearish.  The week started higher, yet closed lower, than the prior week's range (this is called a Bearish Engulfing Pattern); and often signals a trend change.

However, short term oscillators are getting more oversold. As a result, there are probably lots of people looking for an oversold rally next week.

A Leading Indicator of Economic Activity is Dying-Up.

If you are looking for insight into global
supply and demand trends, the Baltic Dry
Index is one of the purest leading indicators of economic activity. It
offers a real-time glimpse at global raw material and
infrastructure demand,
as well as the supply of ships available to move this type of cargo.

Since making a short-term peak in late May (about a month after equity
markets peaked), the index has declined 38%, and
has just dropped below its February lows.

The fear, right now, is whether the recent down-turn will continue.  Meanwhile, there are signs of strength giving hope to the bulls.

For example, disappointing U.S. retail sales data, last Friday, failed to dent the stock market as it closed higher on the day and the week.  That marks the first weekly gain in nearly a month. 

Last week's market action sets-up some pretty clear decision-zones to watch.

First, Let's Look at the Dow.

Despite the recent market correction and fears surrounding Eurozone sovereign debt defaults, the bottom line is that the Dow Jones Industrial Average is only down 10% from its recent peak.  That is not bad, especially considering the length of the preceding rally.

However, a quick look at the chart shows a series of lower highs and lower lows.  This is the classic definition of a down-trend.  Two other bearish things to notice are that price is still under its 200-Day Moving Average and that volume has been weaker on the recent up days.

On a bullish note, the Dow spent a good day-and-a-half below the 9,900 level, yet, sellers did not appear in force … and buyers once again prevailed. Analysts are likely to see a sustained break above the 10,300 level as a bullish sign.

RSI Indicates That We Are Still in Bearish Territory for the S&P 500, as well.

A chart of the S&P 500 ETF indicates that we may have some upside left in the recent bounce.  While the Relative Strength Index indicator remains bearish below its center-line for the SPY, it is close to turning positive.

According to Arthur Hill at StockCharts.com, bounded momentum oscillators trade within a defined range. RSI trades between zero and one hundred, with fifty as the center-line. Think of this level as the 50 yard line in a football game. The bulls (offense) have the edge when RSI is above 50. The bears (defense) have the edge as long as RSI is below 50.

In the chart, below, the yellow areas show periods with RSI below 50, which correspond with declines. RSI met resistance near 50 during each decline (red arrows). In fact, RSI met resistance near 50 twice during the current decline, and it is at that level again.

So, while momentum remains bearish as long as RSI is below 50, this
chart
shows we are approaching a decision point.

What Does the Extreme Fear Shown by Option Purchasers Mean for the Market?

The public often uses the VIX as the standard measure of “fear” in the overall market.  Some prefer to look at option skew instead.  Skew tells the investor how much out-of-the money puts are being bid up versus out-of-the money calls. 

If an investor is scared about the downside, then they buys puts.  If an investor thinks there is room for upside, then they are willing to buy calls.  SurlyTrader posits that when the difference between the implied volatility of OTM puts dwarves OTM calls, then investors are fleeing for the exits.  As the chart below shows, on May 20, 2010, the skew of 3-month options hit a five-year-high.

Depending upon valuations and underlying market conditions, the skew can signal either prescient fear or undue panic.  Consequently, if the spike on May 20th is a positive signal, then we should soon find our own local bottom.

SurlyTrader advises: "If you believe we are close to a bottom, selling OTM puts and buying OTM calls looks very attractive with a steep skew.  Always think about selling insurance when the building is on fire rather than buying insurance after the major damage has already taken place."

The fear, right now, is whether the recent down-turn will continue.  Meanwhile, there are signs of strength giving hope to the bulls.

For example, disappointing U.S. retail sales data, last Friday, failed to dent the stock market as it closed higher on the day and the week.  That marks the first weekly gain in nearly a month. 

Last week's market action sets-up some pretty clear decision-zones to watch.

First, Let's Look at the Dow.

Despite the recent market correction and fears surrounding Eurozone sovereign debt defaults, the bottom line is that the Dow Jones Industrial Average is only down 10% from its recent peak.  That is not bad, especially considering the length of the preceding rally.

However, a quick look at the chart shows a series of lower highs and lower lows.  This is the classic definition of a down-trend.  Two other bearish things to notice are that price is still under its 200-Day Moving Average and that volume has been weaker on the recent up days.

On a bullish note, the Dow spent a good day-and-a-half below the 9,900 level, yet, sellers did not appear in force … and buyers once again prevailed. Analysts are likely to see a sustained break above the 10,300 level as a bullish sign.

RSI Indicates That We Are Still in Bearish Territory for the S&P 500, as well.

A chart of the S&P 500 ETF indicates that we may have some upside left in the recent bounce.  While the Relative Strength Index indicator remains bearish below its center-line for the SPY, it is close to turning positive.

According to Arthur Hill at StockCharts.com, bounded momentum oscillators trade within a defined range. RSI trades between zero and one hundred, with fifty as the center-line. Think of this level as the 50 yard line in a football game. The bulls (offense) have the edge when RSI is above 50. The bears (defense) have the edge as long as RSI is below 50.

In the chart, below, the yellow areas show periods with RSI below 50, which correspond with declines. RSI met resistance near 50 during each decline (red arrows). In fact, RSI met resistance near 50 twice during the current decline, and it is at that level again.

So, while momentum remains bearish as long as RSI is below 50, this
chart
shows we are approaching a decision point.

What Does the Extreme Fear Shown by Option Purchasers Mean for the Market?

The public often uses the VIX as the standard measure of “fear” in the overall market.  Some prefer to look at option skew instead.  Skew tells the investor how much out-of-the money puts are being bid up versus out-of-the money calls. 

If an investor is scared about the downside, then they buys puts.  If an investor thinks there is room for upside, then they are willing to buy calls.  SurlyTrader posits that when the difference between the implied volatility of OTM puts dwarves OTM calls, then investors are fleeing for the exits.  As the chart below shows, on May 20, 2010, the skew of 3-month options hit a five-year-high.

Depending upon valuations and underlying market conditions, the skew can signal either prescient fear or undue panic.  Consequently, if the spike on May 20th is a positive signal, then we should soon find our own local bottom.

SurlyTrader advises: "If you believe we are close to a bottom, selling OTM puts and buying OTM calls looks very attractive with a steep skew.  Always think about selling insurance when the building is on fire rather than buying insurance after the major damage has already taken place."