Thursday, November 18, 2010

Don't Take The Bait

US Stocks are poised to produce a nice upside opening today. Investors might therefore be tempted to conclude that the staple of this bull rally - buy the dips - is back in action and short term profits are in the offing. However, as the accompanying chart shows, when certain market conditions exist any upside move tends to be little more than a bounce followed by a resumption of the pullback. Here are the facts:

Thus far this year, the chart shows that whenever the two primary near term indicators tracked - momentum and MACD - both turn negative - mid January, mid April, mid August, and now - the stock market experiences a bounce that turns out to be a failing rally with a lower low in stocks shortly thereafter. This is made all the more likely this time as an internal divergence (between price and momentum) has occurred twice this year - mid April and now. It is only when MACD then turns negative that price then declines in a sustained manner.

In the April to early July pullback, US large cap stocks dropped more than 10%. The current pullback, however, is unlikely to repeat that magnitude decline (due to the absence of any external divergences). More likely in the 5 to 10% range, with a mid point of 1133, which interestingly sits right above the reverse head and shoulders neckline and 200 day simple moving average of 1125.

Of course, nothing is flawless and works perfectly all the time. But the odds of a healthy market pullback are highest when the above conditions exist.

click image to enlarge

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