Commentary: Warning signs posted up and down Wall Street
By Michael Sincere and Pascal Willain
BOCA RATON, Fla. (MarketWatch) — With so many market indicators giving mixed signals, it’s no wonder that many traders and investors are confused about where the stock market may go next. Some predict a complete collapse of the financial markets while others believe we’ll have a mildly bullish run.
We’ll try to clear up some of the confusion by looking at signals from a handful of indicators. These signals are only guidelines and should not be construed as actionable trades.
Although there are hundreds of indicators, we chose a few of our favorite longer-term indicators. The first two are relatively easy to use and interpret.
Oldie but goodie: Moving averages
Even those who usually don’t follow technical indicators pay attention to moving averages. Looking at the Standard & Poor’s 500-stock index on a six-month daily chart, you can see that SPX is below the 50-day and 200-day moving averages. This does not bode well for the market. The market has indeed started a new downtrend which is defined as consecutive lower highs and lower lows.
We can also see that both the 50-day moving average (points 1 and 4) and the 200-day moving average (points 2 and 3) have been acting as important resistance levels on bounces. This tends to indicate that these averages are closely watched and most probably are included in many automatic computer-trading algorithms.
Follow the trend: Ichimoku clouds
The Ichimoku cloud is a good trend-following indicator. A support cloud is colored in green while a resistance cloud is in red. A bullish trend is broken when the daily cloud’s lower limit is broken.
We can see that point 1 offered good support for the uptrend because the price could not break below. This offered a good probability for a bounce. However, the bounce could not decisively break the upper limit of the cloud (point 2). As you can see, the next down leg pierced through the lower limit of the cloud (point 3), which confirmed an emerging downtrend.
This downtrend was confirmed at point 4 and 5, which offered resistance in consecutive bounces. The red cloud can now be a good guide for a future downtrend. For example, it will be interesting to see if the reversal of July 19 will bounce at point 6 on the Ichimoku cloud or will pierce through it to start a new uptrend.
Note: Look for a break of the upper limit of the red bearish cloud, which would suggest the downtrend is broken, favoring the long side.
Advanced note: Some traders may consider shorting the market if a bounce stalls at point 6 on the lower limit of the cloud.
Experienced traders: Floor levels pivot points
Many experienced traders follow pivot points to identify support and resistance levels. Pivot time periods could be daily, weekly, monthly, quarterly, semester, or yearly. The strongest signals occur when pivots of different time frames converge. The longer the time frame, the more important the pivot might be. For each of these time frames, we can easily build three resistance and three support levels.
A quick pivots analysis on the S&P 500 shows that WR1 (weekly resistance level 1) at 1088.45 converges with the 50 MA at 1089.07. These are set in pink-colored horizontal lines. We can also see that the quarterly and semester pivots are converging at 1092.95.
These strong resistance levels will be difficult to break and some traders may take short positions around these. On the other hand, by looking at the green-colored lines, we can see that the strongest support levels are offered by the yearly pivots at 970.76 and the convergent quarterly and semester support levels 1 at 966.96. These are areas that could mark the end of the downtrend.
Prognosis: The floor pivot levels indicate the path of least resistance, which, at this writing, was down to around 970. The risk/reward ratio is the ratio between a stop loss level that would be set at around 1100 and a target at around 970.
If a trader entered the short trade at 1080, it’s possible to gain 110 points but lose 20 points, which makes an acceptable risk/reward ratio of 1:5.5. The closer to the strong resistance zone you can short, the best risk/reward the trade will offer. On the basis of the present downtrend, the 970 target could be reached around mid to end of August.
Back to the future: Volume
Because of the inclusion of high-frequency traders, volume rules have changed. It has been reported that these traders, using high-speed computers, are responsible for as much as 70 percent of volume on some days. As a result, it’s not always easy to determine the exact amount of supply and demand by short-term traders.
One method we use is a proprietary tool, Effective Volume, which analyzes volume on any security for clues as to market direction. We often apply Effective Volume on the ProShares UltraShort S&P 500, a double-inverse exchange traded fund (ETF).
Why use SDS? It is widely traded, especially by institutional traders. In fact, inverse ETFs are used by institutions to either play a downtrend or hedge long positions. When institutional investors detect that money is moving back into the markets, they often cover their SDS short position, which can be seen and acted upon.
In the figure below, we see that large investors such as hedge funds and institutions have anticipated a reversal of the SDS price downtrend both before June 18th and before July 13th. At the right of the figure (red dotted arrow), the general accumulation pattern on SDS started to reverse, indicating that institutional investors might be nervous about a possible market bounce during this volatile earnings season (remember this is an inverse ETF).
Prognosis: Institutional investors appear worried about a strong bounce being under development, even though their general tendency is to prepare for more downside.
Are all signals go?
Based on the results of the above indicators, we expect further downside over the next one to three months. Obviously, market breadth can change based on a number of factors such as breaking news, economic conditions, and improving fundamentals.
It’s also essential to look at other indicators that might contradict these results. Ultimately, you’ll need to make an objective diagnosis based on the facts. Use indicators for clues as to future market direction rather than relying on personal feelings and emotions.
Let’s not forget that trading is not a game but an investment based on probabilities. An attractive risk/reward ratio does not eliminate the risk altogether. Professional traders are quick to get out of a trade that does not develop in the expected direction and always favor limiting risk over increasing profits.
Michael Sincere is the author of several trading and investing books including All About Market Indicators(McGraw-Hill, 2011). Pascal Willain is the author of Value in Time: Better Trading through Effective Volume (Wiley Trading, 2008) and owner of the website, www.effectivevolume.com.
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