Saturday, May 17, 2008

A Bullish and Bearish Outlook for the Markets

I've said this before, but I really do think we may be reaching an inflection point in this market where we either get a rush of buying from the institutions, which pushes us to new highs and a new bull market, or a breakdown at these levels, pushing us down to challenge the March lows. The problem is that I have no clue as to which of those it will be.

I tried to look at the charts of the indices from both a bullish and bearish perspective. Here is what I saw from the bulls' side. The inverted head and shoulder patterns can be seen on most charts and former resistance levels have now seemed to have turned into support levels.

Dow and S&P 500 - BullishNasdaq and Russell 2000 - Bullish
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

Here is what I saw from the bearish side. It seems like bearish wedges are being formed right now - you can check out some information about this pattern here courtesy of I found this paragraph the most interesting.

"The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline – other aspects of technical analysis should be employed to forecast price targets."

That description looks very accurate to me. Upside breakouts are possible from this pattern but very rare, and would need to be accompanied by huge volume to confirm a breakout.

Dow and S&P 500 - Bearish
Nasdaq and Russell 2000 - Bearish
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

Looking at the VIX, I found it interesting that we are at the same levels right now as we were in early October, 2007, which was the start of this current bear market. If we hold these levels, perhaps this rally is done. If we break lower on the VIX, perhaps we have higher to go.

Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

I don't use the McClellan Summation Index too much, but I checked it out today and noticed some interesting points of data. Similar to the VIX, this indicator has risen to the exact same levels as it was in October 2007(actually it is slightly above right now). However, price on the indices has not risen anywhere near the October highs. I would have to take this as a positive divergence.

McClellan Summation Index
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

Some other bullish points to consider:
  • Plenty of new stocks have emerged and made nice moves over the past month.
  • The Nasdaq is leading the market and has risen above its 200 day moving average.
  • Earnings overall were better-than-expected from what I could see.
  • It seems like there has been some rotation into tech from commodities.
  • There is a ton of short-interest out there as trader continue to short every single rally.
  • Put/call ratio jumped back close to 1.0 on Friday with just a little selling - some fear is still out there.
Some other bearish points to consider:
  • We are overbought - not at extremes, but definitely overbought.
  • Sentiment is a little too bullish (46% bulls vs. 30% bears on Investors Intelligence, 45% bulls vs. 30% bears on AAII survey,
  • Volume continues to be below average.
  • Seasonal tendencies point to lower prices.
  • Speculative, beaten-down stocks have made big moves the past week, often signifying "frothiness" is the market and a possible top.
  • Oil continues to climb to record highs, which is nice for the energy sector but at what point will this affect earnings for all other sectors?
  • Commodity stocks have yet to put in a true top.
Two weeks ago, I outlined a scenario in which I thought the market was starting a topping process. This is what I said then:

"Based on these charts and a few other reasons, this is my current thesis about this market and where we are headed. Mr. Market likes to bring as much pain as he can to as many market participants as possible, and usually is successful in doing so. Right now, there are still a ton of people shorting this market, and although bullishness has increased, it is not as extreme as it could be. We are right at or almost at the 200 day moving average on all indexes, and I am sure the bears see this as heavy resistance. If we get over these levels, I thing that many of the up-to-this point stubborn bears may throw in the towel, cover their shorts, and begin to go long, figuring that this market is indeed headed higher. Because of this, I would not be surprised for the market to rally for another week or so. I can't see us heading that much lower with as much short interest as there is right now.

I still, however, have a hard time believing our economy is now completely over this credit crisis and everything is all of a sudden A-OK. For the most part, this rally has seemed to be driven by retail traders and short covering, and at some point, they have to run out of steam. They can't carry a market on their own for long periods of time - the institutions do that, and they have been absent for the last month and a half. When the last of these retail traders get pulled in and start buying, I think that's the point we turn. I don't know if we're there quite yet, but I think we are very close to that point. "

I have no idea if my scenario will prove to be true - if nothing else, I know that I was early in predicting a top. I still see this scenario as a possibility - as we grind higher, these shorts have to be getting a little antsy. With this much short interest in the market(almost 14 days worth on the NYSE), there is fuel out there for a major move higher. I have no way of knowing if this will happen, and it probably won't unless the institutions jump aboard. I could still see us moving higher, pulling in these shorts and the last of the retail bears, before heading lower. Perhaps a breakout above the wedge pattern we see on the indices would act as a perfect bull trap.

Although this scenario could play out, I am not betting on it yet. Be ready for it, but don't act on it too quickly. There are just too many question marks on either side for the market right now to put money on "predictions". The bulls deserve some respect here - there are some very nice charts out there and there have been many chances to make some money over the last month or so. Basically, I think the smart play is to continue to play the current trend (which is clearly bullish) until evidence shows that this trend is over. This will come with 2 or 3 days of heavy selling (which we haven't really had yet) and a breakdown below support levels. These are the levels I would watch for(listed in order from short-term to medium-term):
  • Dow Jones - 12, 911 / 12,845 / 12,750
  • S&P 500 - 1410 / 1397 / 1387
  • Nasdaq - 2515 / 2500 / 2470
If we break below these levels, especially on higher volume, then I think we will be headed much lower. As you can see with the information above, however, it is very hard to tell if that will happen with any certainty. This market is still a challenging one, no doubt. I still enjoy it though, I do know that. Perhaps next week we will get a little more clarity as to where we are headed. See you Sunday - I will try and post some individual stocks charts then.

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