Three Reasons Why Tech Looks Ready to Rally

By Bernie Schaeffer

Bernie Schaeffer is Founder and CEO of Schaeffer’s Investment Research, Inc. and Senior Editor of the Option Advisor newsletter since 1981.

There are a number of reasons to expect strength in the months ahead in the PowerShares QQQ Trust (QQQ), but this report will focus on some very compelling (and very bullish) technical factors that support the premise of a fourth-quarter QQQ rally that could approach 20% (or more).

1. Market indices often encounter price hesitation or "congestion" at round-number price levels (such as $70) for a number of logical reasons. For example, traders will often target overhead round-number levels for at least initial profit taking on rallies. And the fact that activity in call and put options is most often the heaviest at round-number strike prices (as measured by the open interest levels at these strikes) adds further to the "congestion," as adjustments by those holding (or hedging) options positions often have a tendency to create mean-reverting movement toward the strike price. But it is lesser known that a similar "congestion" phenomenon also applies to round-number percentage gains from a fixed starting point, most often in the form of the year-to-date gains (or losses) in the major stock indices. So, for example, the roughly 7% pullback in QQQ from its May peak to its late-June lows was ultimately supported at a level ($71.64) corresponding to a 10% QQQ year-to-date gain. And then, in early September, the QQQ experienced quite a bit of congestion near $78. Based on the round-number percentage gain phenomenon, this turns out to be less than surprising, as $78.16 represented a 20% QQQ year-to-date gain. But ever since Sept. 17, QQQ has not closed below $78, and almost all QQQ intraday pullbacks have been contained above the key $78.16 level. This recent price action bodes well for QQQ overcoming its September hesitation at "+20% year-to-date," and opens up a strong possibility for a renewed thrust higher in October.

2. Technicians usually focus on short-term indicators, and by so doing they can miss out on some very significant long-term phenomena. For example, market rallies will often hesitate at multiples of a previous low, and market declines at fractions of a previous high. Common areas of hesitation would include twice the most recent major low or half the most recent high, but higher multiples and lesser fractions (sometimes as small as 10%) can also come into play. In the case of the QQQ, $75.15 represents three times its November 2008 low of $25.05. And, as I'll note when I discuss my third and final basis for a firmly supported QQQ primed for a major fourth-quarter rally, when the QQQ moved above the $75 level in July (and also successfully tested $75 as recently as August), it managed the very impressive feat of leaving two potential hesitation points in its wake.

3. Back at the peak of the tech "bubble" in March 2000, the QQQ actually traded as high as $120.50 (marked by the "X" in the chart above). After a sickening plunge to as low as $19.76 in October 2002, the QQQ remained adrift until it took out the $60 level in January 2012, and then successfully retested this level in June 2012. And yes, this also represented a successful negotiation of the $60.25 level - half the March 2000 all-time high. But after the ensuing rally of roughly 30%, the rubber has again met the road for QQQ as a result of its recent encounter with a level that may be obscure for many less-technically oriented investors, but which is on the radar of most market technicians - the so-called 0.618 Fibonacci** level relative to the QQQ all-time high, which sits at $74.47 (as indicated on each of the accompanying QQQ charts). And sure enough, the QQQ did wrangle with this "61.8% Fib level" in July, first taking it out on the July 11 gap rally, and finally successfully retesting $74.47 on the pullback on July 23. While the short-term hesitation by QQQ at this Fibonacci level was palpable, in the bigger picture it was a very impressive "release" from potentially troublesome resistance, and bodes very well for the fourth-quarter QQQ strength I am expecting.

To summarize, the QQQ has gained roughly 20% year-to-date, but the path to this "+20%" has been choppy, with lots of sideways action and corrections along the way. However, based on the QQQ's very bullish behavior relative to the confluence of the three key technical levels we've just reviewed, the final three months of 2013 offer the potential for a "take no prisoners" QQQ surge that could easily match the 20% gain posted over the course of the first nine months.

** The Fibonacci sequence, as discovered by 12th century mathematician Leonardo Fibonacci, refers to a series of numbers beginning with 0 and 1, with each successive integer representing the sum of the preceding two: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on. As the sequence continues, the ratio of each number to its immediate predecessor converges toward 1.618 -- a figure known as the "golden ratio," due to its prevalence in nature. For example, this ratio is thought to dictate the arrangement of leaves on tree branches, spirals in sea shells, planets within the solar system, and even the human DNA molecule. The ratio also crops up frequently in architecture, with famous examples including the Great Pyramid of Giza, the Parthenon, and the Taj Mahal. The inverse of the golden ratio is 0.618.

Charts courtesy of TradeMonster