Warning Sign and Silver Lining

The market was doing price discovery in the past few days and some warning signs popped up.

As mentioned before, bar 2 made a new high with lower volume, showing the resistance above is diminishing. Bar 4 made a new low with higher volume (than bar 2), which shows the support from the downside is stronger than the resistances revealed by bar 2. So far still healthy. However, when bar 5 made another new high with higher volume (than bar 4), it shows more resistance came from the upside. Finally, bar 6 made a new low with lower volume (than bar 5), showing the support is weakened. Although this does not point to an immediate sell-off as the price discovery is still on going, the tone of the market clearly changed.

That said, there are still silver linings I would like to point out.

1. As shown above, the important support (detailed here) still holds. And today the market closed above the support area, meaning the support worked and pushed the market back upwards. The market is still range-bounded.

2. The two defensive sectors, Healthcare and Consumer Staples, kept making lower lows and lower highs in the past few days, suggesting that the market is drawn down by them. When investors expect the market will move higher, they will rebalance their portfolio to reduce holdings from defensive sectors and increase that from offensive sectors, in order to make more profit. So bulls should not worry if defensive sectors led the market down. Please refer to this column of Barron's for detailed discussion on defensive and offensive sectors (may require subscription).

3. There are two offensive sectors, Technology and Financial, making higher lows, while the market is making lower lows. This supports the conjecture that defensive sectors drive the market down.

The price discovery, the range-bounded consolidation, and the potential portfolio rebalance are all indecisive market behaviors. To conclude this, a decisive move out of the range is expected, which is normally forceful and could be damaging. Given the warning signs, it might be wise to take some profit or hedge the risk, at least start thinking about it.

Not Bearish, Yet

It is not pleasant to see the strong momentum stopped suddenly and the market stayed where it was for 3 consecutive days. Worry is spreading and it appears legitimate to take profit and even plan to short. However, the technical evidences I saw so far do not point to much downside, and taking a short position might be premature.

On the daily chart of S & P 500 Index, bar 2 and bar 3 made new closing high. Because day traders will pull out of the market at the end of the day, the market shows its real direction at the closing price. A market keeps making new closing high is not bearish.

The volume of bar 1, 2, and 3 was below average and decreasing. This eliminates the doubt that big players are distributing chips, a usual action they will take before driving the market down. Furthermore, bar 1 and 2 made new intraday high with decreasing volume. This shows that while they retreated from the intraday high, they were not pushed down by fresh selling. If there was any resistance, the resistance is diminishing.

On the 15 min chart, price stayed above the blue line in the past three days, it cannot even go down to test the blue box, a strong support denoted by both the intraday gap and the previous high. Moreover, the majority of the trading happened above the green line. The blue line is barely touched twice. Because the blue line and the green line mark the consolidation range of Aug. 21st, this shows that many buyers are waiting in this area to buy dip.

It's an old saying that armatures open the market and professionals close it. On Aug 24th and 25th, the market raised at the open and dropped at the close. But today it dropped at open and raised at close. This indicated a subtle switch of mood between armatures and professionals. The real move may begin once most armatures are confused and step back to the sideline.

At last, it's safe to say that market has its own rhythm. When it moves and where it goes are myths to most of us, including me.

Take Beta Into Account

Bespoke Investment Group's blog today has an insightful post comparing the gains of each sector of S & P 500 in the recent rally. Although this doesn't tell us where the market will go, it offers trading ideas for both bulls and bears as one always want to long sectors that are stronger than the market and short the weaker ones.

According to the numbers above, Energy sector, with a gain of 8.3% since 8/17/2009, is the best performer in the latest rally. Because it was not the best one in the two previous rallies, the one starting from 3/9/2009 and the one from 7/10/2009, Bespoke's analysis shows that trader's interests are shifting from Financial (the previous hot spot) into Energy. Thus, if the rally continues, bulls may want to long some energy stocks to take the advantage.

As you may already know, there are a couple of mysterious Greek letters in the investment world. Among them, beta describes the relative speed a stock moves with respect to the market, which is usually benchmarked by the S & P 500 Index. For example, a stock has beta 2 will move 2% if S & P 500 moves 1%. Thus, the 8.3% gain of Energy may not necessarily mean that it is stronger, it might be that Energy happens to have a larger beta. If so, Energy would drop faster when market turns, and longing it would not be an advantage anymore.

I adjusted Bespoke's numbers by the beta of each sector and list them below. Since I don't have sector's beta available, I simply use that of the corresponding SPDR sector ETFs as a proxy. I also listed their difference to the S & P 500 Index, to show the relative strength.

As it shows, Energy is still the best performer. However, the worst performer is now Technology. The minimum 2.68% advance of Consumer Staples just reflects that it has the lowest beta among all sectors.

Please note that this analysis doesn't equal to a suggestion of shorting Technology at this moment. If the rally keeps going, all sectors will get lifted. Likewise, it doesn't not guarantee profit of longing Energy. It simply says that longing Energy is potentially more profitable if market keeps going up.

In Sync With Barron's

I take it as a complement when I saw Michael Santoli saying in today's Streetwise column of the Barron's (may require subscription) that

Frequently this summer, the pre-market direction is obeyed at the New York open, after which the indexes stall. In nearly half of all trading sessions since June, the overnight index change has exceeded the move from U.S. open to close.

This aligns with my view expressed in the post "The Missing Part" that future market dominated and led the stock market recently. Michael went on to explain that the future market is driven by "the influence of global marco sentiment" and emerging markets in Asia and Europe are the leaders.

Another Michael's point worth to mention is on the so-called "profit leverage indicator".

Morgan Stanley strategists point out that employee compensation fell by an unprecedented 6% in the most recent reported 12-month period, while productivity growth -- in defiance of past recessionary patterns -- remained positive.

Jim Paulsen of Wells Capital Management maintains a "profit leverage indicator" derived from measures of business productivity, total unemployment and factory unemployment. It has skyrocketed to levels not seen since the mid-1970s.

Surely this will refresh bulls' hope and should be taken as a warning sign by bears.

Indisputable Strength

I have to confess that the bullish view in my last post was pure tactical. I'm a bear deep inside, convinced by the huge drop on Monday and my long time suspect to the fundamental. That's why I need to have more proof to work against my bias and make me admit the strength of the bull: the upside target could be around 1050.

Look at 60 min chart first. The green line is a support turned from a resistance. It's a valid support / resistance as it has been tested from both sides. The red line is a valid resistance line as it was tested intensively on Aug. 12th and 13th. The market was consolidating within this range and finally it broke out the resistance today. Adding the height of the range to the break out point gives the target at around 1050. Furthermore, the two intraday consolidations (the two blue arrows) that align with the 38.2% and 61.8% Fibonacci points also support the analysis.

On the daily chart, we see the break out is supported by higher volume. The increasing volume in the past four days also shows that the rising has drawn more and more supporters. The range of the bars is also increasing, eliminating the doubt that the rising volume is caused by distribution.

Then on the weekly chart, 1050 was a previous high, another technical evidence pointing to the same target. Clearly we are in an up trend and betting against it would risky. The concern is that the volume this week, a break-out week, is not impressive. Nonetheless, price is the most important, everything else is secondary.

Finally on the 15 min chart, I see a flag, which is a continuation pattern that pointing again to the same target at around 1050. The up side break out of the flag already happened this afternoon, showing that eager traders don't even bother to wait until tomorrow. Another thing is the gap marked by the blue box. This is something we won't normally see in an intraday chart. The gap matches with the previous high, simply showing how violent the bull was when breaking it.

All these sum up to one conclusion. I may still suspect the fundamental. I may still be a bear deep inside. But I will not express it with my cash at this moment.

The Missing Part

The support at the red arrow seems come out of nowhere to me at first glance. Later on I realized that, by zooming out a little bit, it's the lower boundary the market formed six days ago. Not completely satisfied, I looked around and found an important missing part of the pattern.

The E-Mini was consolidating withing a channel (the yellow lines) in the past three days. Most of the consolidation was hidden away from stock traders while they were asleep. After breaking out, the upper channel was tested and here comes the support level, marked by the yellow arrow in the E-Mini chart. The consolidation, plus the successful test, plus the sharp bounce off from the upper channel, makes a strong bullish case with target at least around 1005. The length of the consolidation and the sharp retest do increase the probability for a higher target. Nonetheless, it is possible that the future market hits the target in the night and tomorrow morning when stock market opens it returns to today's closing level, or even worse.

I feel kind of frustrated as a stock trader because the battle field is not the stock market. The major movements are in the future market and stock traders could not do much other than following the future market. This reflects how tough the trading could be during an OE week.

Another thing alerts me is the giant sell-off at Sunday night. It revealed overwhelming downward forces. Trading a stock market that moves against it would be tougher.

Short-Term Top of S & P 500

The first pattern caught my eye is a tight downward channel (green channel lines in the chart above), which shows forceful sell-off meeting almost no resistances. Usually this means that big players are distributing chips and everyone else are trenched. Then there is an ascendant triangle (blue lines), featured with sharp bounce-offs (blue arrows) on the lower boundary. If taken isolated, sharp bounce-off is a positive sign that shows eager buying into the up move. However, it smells fishy as they are right after a forceful sell-off. It wouldn't be difficult, in a short period of just two days, for market makers to forge such a pattern, simply to lure in traders and off-load chips they inherited from the preceding sell-off. There is one more proof supporting my suspect, if we ignore those spikes inside the ascendant triangle, we see a bearish rising wedge (orange lines) embedded in it. The following downside break (red arrow) and sharp sell-off justified its bearishness.

Now the tricky part is to predict where the index goes the coming week. Without risking my reputation, let me just put down some doubts at this moment.

1. The green downward channel distribute chips from big players to market makers, and the bearish rising wedge distribute chips from market makers to the rest of the market. It takes time for the market to digest them. Judging by the timeframe of the two distribution, the next week, and probably more, may not be pleasant.
2. The intraday round bottom on Friday simply shows that the selling pressure is trimming off. One question to ask is where is the eager buying we see the day before? Because traders suddenly change their bullish view overnight? Or, more dangerously, because all potential buyers are sucked in?
3. And the buying power at the round bottom could be pure speculative because of its short timefame. Further more, it makes no more than a 50% retracement.
4. The overhang above Friday's close is now technically at risk, especially if they are hold by retail traders. Every down tick will press them to sell and add more fuel to the selling.

All that said, it's possible that new buying power comes in and kicks off another rally. But it seems that there is no more eager buying from those who fear to miss the train. Knowing that panic will drive the market down, new buyers will be waiting somewhere down below.