ANALYTICAL TOOLBOX: Intermediate-Term Outlook

At this point, these charts display intact upward trends that are being tested. Move down in intervals to gain insight on the shorter-term view. In case you’re not aware, it’s volatile out there. This week’s focus will be the intermediate- and shorter-term trends.

Current Worries

Before looking at charts, traders should be aware of potential problems with the end of quarter fund reporting that could flush out some more problems on the hedge fund side. According to the financial media, there are at least two fund issues worrying the market in the short-term. The first relates to fund problems that are not yet visible because the portfolios trade in less liquid securities that lack a current market for the funds to mark-to-market.

Funds may be reporting stale prices or valuations that are much better than the true market for the security. If one fund has to unwind positions before things improve, then a current price is available and other funds will need to value their portfolios at this lower price. This could create a negative domino effect, but be aware that this may or may not happen.

Regardless of positions being unwound, the end of August marks the fiscal end of quarter for some funds, requiring reporting that could give better transparency to problems that exist now, but remain unseen for the moment. Hedge funds with and end of quarter on Sep 30^th face a different problem—investors who are not wanting to ride out the market need to request redemptions 45 days in advance, or by August 15^th. Positions unwound to meet redemption requests could pose additional problems.

Keep in mind that many market participants are aware of all of these issues. There could be a strong market reaction before Labor Day as a result of positions being unwound or in anticipation of good or bad news at the end of August. Immediately after if the news is counter to market expectations another strong reaction could ensue. Bottom line: expect volatility to continue for a few weeks.

If you’re considering establishing protective bearish or bullish positions, the only thing you can do is work your way into those as the market displays momentary strength or weakness in the other direction. Watch support and resistance areas that may indicate a resumption of the long-term upward trend or a breakdown of it.

Nobody knows what the next week or week after will bring, so do your best to monitor conditions and actively manage what you need to manage. If the markets are completely stressing you out, consider heading to the sidelines with trading dollars and reasonably protect your investments.

On the technical side, September, a traditionally bearish month looms ahead, along with memories of the 1987 crash. Since we’re in a year ending in 7, technical analysts have two cycle areas to consider: 1) the ten year cycle and the 4) four year presidential cycle. The former can include overall down years for the market for years ending in 7, while the third year of the presidential cycle may be up, with a serious down draft along the way.

Remember that a cycle low does not equate to a new market low—look at last spring’s four year cycle low to gain some perspective on that concept. Also, if worried about a 1987 repeat, take a look at what was happening daily then. The markets won’t repeat past activities, but convincing yourself one way or another requires you to look back for a reality check, but ultimately focusing on what is actually happening in today’s markets. It’s not a forecast of any kind; you need to look at conditions to keep your emotions in check so you can respond accordingly.

Current Conditions

The S&P 500 Cash Index () made a strong break down yesterday below the middle regression line of a 3-year regression channel initiated on 3/3/2003. There are times an index or stock will remain choppy near the regression line; however the strong bearish readings in Stochastic (settings: 12, 5, 5) and MACD (settings: 6, 13, 4) suggest it will travel further down away from this line, similar to Apr-05 and May-06. If these indicators continue to look bearish, the lower channel line may be the next target (at approximately 1320). In the intermediate term, continued downward movement seems more likely; however whether this carries to the lower regression channel line is something that requires monitoring. The index remains below the 50-day and 200-day exponential moving averages [EMAs].

Figure 1: Weekly Chart of SPX with Stochastics and MACD

The weekly Dow Jones Industrial Average () chart displays an index level just at its 200-day EMA. Although this generally represents an area of strong support, weakness in the broader SPX doesn’t bode well for this support area holding given weakness in both Stochastics (settings: 12, 5, 5) and +DI/-DI (setting: 9). Stochastics in particular may suggest an intermediate bearish picture since the fast line moved strongly down below the 40 area which would have served as a bullish support zone.

INDU moved well above the upper line of a 3-year linear regression channel initiated in Oct-03. Assuming it breaks down below the 200-day EMA and continues its bearish move on an intermediate basis, the upper channel support line will be reached around 12,300. If the 200-day EMA holds, a second channel will be added starting around Jul-06 to reflect the accelerated upward move in the index.

Figure 2: Weekly Chart of INDU with Stochastics and +DI/-DI

The Nasdaq 100 Index () has held up better than the SPX and INDU, but is currently following suit to the downside. The weekly chart displays the index approaching the middle regression line of a 3-year channel initiated in Mar-03. Stochastics (settings: 12, 5, 5) is at a bullish support zone while the ADX (setting: 9) is signaling a lack of trend and +DI/-DI is bearish. Given the strong bearish nature of SPX and the moderately bearish INDU, it seems that there is more bearish evidence for NDX.

Continued downward movement would bring the NDX to the middle regression channel line at about 1825. It seems reasonable to monitor Stochastics and the other two indexes as NDX approaches this level.

Figure 3: Weekly Chart of NDX with Stochastics, ADX, +DI/-DI and OEX Overlay

The daily chart for the Select Sector SPDR S&P 500* () shows the exchange traded fund [ETF] has also broken down below the middle regression line for a 3-year channel initiated in Oct-03. The same settings for Stochastics and MACD display bearish conditions with the ETF Stochastic recently facing resistance at 40. This shorter term bearish chart suggests continued weakness for both the short-term and intermediate term for both the ETF and its proxy index—the SPX.

Figure 4: Daily Chart of SPY*

Last week a daily view of the NYSE Composite Index () was displayed along with the daily Arm’s Index () for the index. Updated versions of both charts appear in Figures 5 and 6, with chart details for the Arm’s Index appearing at the end of the chart.

The strong bearish day on Wednesday moved the index closer to the lower regression line for a 4-year linear regression channel initiated in Mar-03. So this chart provides a longer-term channel than the others displayed in Figures 1-4. You may want to extend the channels for the other indexes and ETFs. If it still appropriately captures the data, a revised lower regression channel line may be merited.

Given bearish MACD and +DI/-DI readings and what’s happening in the other charts, it seems reasonable to assume NYA will reach the lower channel line around 8800. Signs of a bullish divergence will be monitored in the interim. If and when this lower channel is reached, indicators will be checked to gain insight as to whether or not this will hold as an area of support.

Figure 5: Daily Chart of NYSE Composite Index

The Arm’s Index is displaying negative breadth; however Wednesday’s reading of 1.32 improved on Tuesday’s reading of 1.92. This reflects only a very short-term improvement. Both the 21-day and 55-day EMA are trending downward. It seems a one day reading needs to show more weakness to suggest a reversal. More needs to be analyzed on this indicator, but Wednesday’s market action seemed to warrant more of a focus on the weekly and daily charts.

Figure 6: Daily Chart of NYSE Composite Arm’s Index

Summary

I told a good friend of mine recently that even though right now I have some substantial project deadlines to meet, an important sporting event in a few weeks and I’m currently trading these markets, the thing that keeps me up at nights is people’s reaction to my market outlooks. I have images of someone at a poker table saying “all in” to new positions or “fold” and walk away when open positions remain in their account. It’s partially why I add intermittent reminders of “nobody knows what’s next”. The best advice:

Monitor what actually “is” and be careful about anticipating what’s next,Try to establish areas of basic support and resistance and note the market reactions in those areas—preferably when the markets are closed,Monitor your emotions and do what you can to manage them,Check the percentage of the portfolio that positions you’re concerned with represent to gain perspective on actions you need to take (or not),Establish partial positions or take some profits off the table rather than thinking it’s all or nothing, andRemember there’s always another day to make money in the markets, don’t chase positions and if you’re out of sync with your trades, step away for a bit.

For more information on the Arm’s Index, created by Richard Arms, Jr., checkout Richard Arms’ 1989 book The Arms Index: An Introduction to the Volume Analysis of Stock and Bond Markets.

The final chart is different than a typical stock or index chart and requires explanation. It displays the Arm’s Index, also known as the Trader’s Index or TRIN. The daily Arm’s Index readings are displayed by a thin, light grey oscillating line on an inverted, logarithmic chart. It is logarithmic to normalize the readings a bit and inverted so that extremely high readings which are bullish are on the lower part of the chart and low, oversold readings appear on the top of the chart.

The 21-day and 55-week EMAs also appear on the chart. Finally, a series of horizontal lines are also displayed as follows:

1. At approximately 1.0 is a dark, solid line which designates a neutral area for the index.
2. Thinner black lines also appear above the neutral area at 0.70 and below it at 1.20. These represent moderately extreme daily readings for the index which are generally used to indicate a lower opening the next day [less than 0.70] or a higher open the next day (greater than 1.20).
3. A light grey dotted line at 2.85 identifies an extremely bearish day.

The final two dotted lines are at 4 and 0.3 to display the most extreme days.

* Registered name.

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Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site