Ring- Ring. Investors got a wake-up call, but is it serious enough to get out of stocks or can we hit the snooze button and expect new rally highs or at least stable prices?
Unfortunately, there's no simple yes or no answer, but we'll get a better feel of whether stocks are ready to head south for the summer by looking at various data points, indicators and gauges.
Spot Top 101
Spotting a market top is tougher than a bottom. Why? The predominant emotion found at tops is optimism and complacency. The overriding emotion at bottoms is fear and capitulation.
Fear is a much stronger emotion, often expressed in swift capitulation moves. Tops, on the other hand, are a process that lulls investors asleep; therefore the term 'topping process'.
I find bottoms to be easier to call than tops. Even though calling market bottoms and giving buy signals is ironic for a guy who's more of a long-term bear, I feel a smidget of pride for calling the October 4, 2011 and March 6, 2009 bottoms within 2-4 days (buy signals were published in the ETF Profit Strategy Newsletter and sent to subscribers).
Despite much uncertainty, hunting for market tops is still worthwhile. Once a top is in place, the ensuing decline tends to sport a trajectory that's much deeper than most rallies (2010 Flash Crash and 2011 summer crash).
I use a composite of technicals, seasonality, sentiment and most importantly, resistance levels, to identify and narrow down a top in the making.
Targets and Resistance
"The S&P has surpassed the 1,364 – 1,382 resistance range. This resistance cluster was strong and the break above is bullish. The next resistance levels are 1,425 and 1,4xx (reserved for subscribers)," is what the March 16 ETF Profit Strategy Newsletter said.
The S&P got within a couple of points of 1,425 (April S&P high was 1,422) before reversing (see chart below). Resistance at 1,425 was obviously strong enough to repel the S&P (NYSEArca:SPY - News), but since the reversal occurred before actual resistance was hit, it's prudent to allow at least for the possibility of another attempt to make new highs.
The March 16, ETF Profit Strategy Newsletter brought out that all but one top since 2007 saw a divergence between RSI and price on the weekly chart. There was no such divergence back in March.
Today we see a small but noticeable divergence on the weekly chart where the S&P (SNP:^GSPC - News) did not top until last week while RSI peaked in mid-March. We see a similar divergence in the Nasdaq (Nasdaq:^IXIC - News) and Dow Jones (DJI:^DJI - News).
The divergences are not as pronounced as I'd like to see them, but they do fulfill the minimum requirement, and with seasonality turning bearish (who doesn't know about "sell in May, go away"?) it would be short-sighted not to be prepared for prices to turn lower.
First, The Topping Process Continues
Tuesday's sell off was a 90% down day, which means that 90% of all trading volume occurred on the sell side. It's easy to panic and turn bearish at times like this, but the April 10 ETF Profit Strategy Newsletter highlighted the stretched condition of the market (VIX closed higher for 8 consecutive days for the first time ever) and likened the market to a stretched rubber band that's ready to snap back. The snap back happened Wednesday and Thursday.
It is dangerous though, to get too excited about those snap back rallies. All they may do is create a false sense of security and prevent investors from selling in time for the next leg down - the old bait and switch.
Navigating the current ups and downs with support and resistance levels is (in my humble opinion) the most effective way to stay out of trouble and identify the next profit opportunity. The chart below shows some of the support/resistance lines identified in previous ETF Profit Strategy updates (notes how encounters with resistance and breaks below support increase selling pressure).
As long as stocks remain above support, we will allow for higher prices, but as soon as stocks drop below resistance, it's time to buckle down and/or go short.
Support/resistance levels are unique in that they provide boundaries for stocks. Like in golf, stocks do better as long as they stay within defined boundaries but get into trouble when out of bounds.
The ETF Profit Strategy Newsletter pinpoints upcoming resistance levels that could stall the recent bounce and the support level that – once broken – would lead to much lower prices and quite possibly to a 2010 or 2011-like meltdown.
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