Tuesday, October 6, 2009

Two Technical Analysis Risks to this Rally

Last week’s Divergences on the Horizon posting gave the long and near term context for concern re the cyclical bull rally since March. This week I would like to zero in on the very short term price action in the form of two charts that I believe illustrate the key technical analysis areas to keep a close watch on.

The first chart* highlights the divergences point mentioned last week. Since the S&P 500 hit its intra day of 1080 on September 23rd, the five indices tracked (represented by the large cap S&P 500 (SPX), mega cap S&P 100 (OEF), mid cap S&P 400 (MDY), small cap S&P 600 (IJR), and micro cap (IWC)) have followed the proper correction rules as the higher risk sectors (MDY, IJR, and IWC) dropped more than the lower risk sectors (SPX and OEF). However, now that we are in the midst of a rebound rally (that must exceed its first rebound high of 1070 – more on this shortly), the higher risk sectors must follow the rally rules and outperform to the upside. As the first chart shows, the price action is showing signs that the second tier on down sectors are not doing what they’re supposed do – revert back to outperformance. Maybe they will. And that is precisely the point, and the tie in with earnings season.

Should we experience a bifurcated earnings season (see September 23rd blog posting "V Shaped Rally ≠ V Shaped Recovery"), the price action of the large versus mid and lower cap sectors should complement the real economy results. If so, a major divergence will occur as large caps make a new high BUT the Smids on down do not. Stay tuned.

The second chart illustrates a key point referenced in this week’s “Sectors and Styles Strategy Report”**, which deals with the potential of a failing rally. At present, all systems look like a go for a new high and the aforementioned potential divergences. However, a failing rally in the form of a lower high cannot be ruled out.

As the second chart* shows, the key price point in the S&P 500 is 1070 – the lower high reached last Tuesday. The risk here is for yet another lower high producing the bouncing ball down the stairs effect – lower highs followed by lower lows. This pattern, it should be noted, is usually not easy to identify until after the fact. To spot the failing rally during the fact requires a look at the power behind the move in the form of the index’s momentum and MACD, both of which are mediocre at best (for spacing purposes not shown but take my word for it, it is so).

Investment Strategy Implications

On September 24th I made the following short term forecast, “Three percent to 5% down right now, followed by unconfirmed new highs, followed by a 15% to 20% correction. Can’t get more specific than that. Now, let’s see what unfolds.”

Well, here we are. The first part of the forecast has delivered, now let’s see what follows.

*click images to enlarge
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