Tuesday, November 23, 2010

Time To Digest

Those who heeded my Thursday last blog posting warning not to take the bait have been rewarded with +167 basis points thus far and are likely to benefit further in the coming days and weeks as the near term indicators tracked – momentum and MACD – are now even more solidly entrenched in pullback mode as the accompanying chart clearly illustrates.

Poised to close below last Tuesday’s closing price of 1175, the S&P 500 would join its major global markets brethren (EAFE (EFA) and emerging markets (EEM)) with downside price confirmation of the negative momentum and MACD trends warned of last Thursday. With the short term indicator (slow stochastics) well above its oversold territory (below 20), a pullback target to the average of 5 to 10% is more than achievable and would drop the S&P 500 to the most interesting price of 1133, or just above its head and shoulders neckline and 200 day simple moving average right around the 1125 price level before then signaling an end to the pullback.

Why Not More (Or Less) Of A Decline?

Since the market action that preceded this pullback lacked any external divergences and considering the fact that 100% of the 30 indices tracked are in bullish Mega Trends, the market only had the less serious internal divergences to work off. Accordingly, the magnitude of the current decline should be muted.

As for the decline stopping right here, that is not likely as the internal divergences are so solidly tilted to the downside plus the fact that the other major indices are also performing in like fashion. Such action rarely stops dead in its tracks and reverses itself without first producing signs of trend change.

Why Do Divergences Work?

It is important to remember that this divergence stuff I keep emphasizing works because of the nature/structure of the market. With so many market players operating in the short term space dominated by the need to match performance and with a philosophy of momentum investing, trends that get established tend to stay that way until they are exhausted thereby producing divergences. It is for we investors and traders who can correctly exploit this momentum lemming-like behavior by either joining or going against (contrarian) the crowd that can reap the absolute and relative performance rewards.

When Will It Stop?

The key bullish signs to watch for are the same ones that warned of the market decline we are now experiencing: divergences both internal and external. Specifically, the point at which momentum and MACD do not confirm lower lows will be time to consider increasing the equity exposure. Whether external divergences develop will factor into the decision process at that time.

Like a Thanksgiving meal, it is always good to digest some of what you ate before gorging yourself again on the simplistic “don’t fight the Fed” tune.

Note: My appearance yesterday on foxbusiness.com with Tracy Byrnes is available on my media blog Beyond The Sound Bite.

click image to enlarge

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