Sunday, October 18, 2009

Technical Update 40.09

The major indices finished the week higher, a feat achieved 24 of the last 34 weeks (70.5%). Rising stock prices seem to be ingraining themselves into the collective conscience of market participants even as confidence measures remain somewhat benign. It tells me that while many do not believe the economic recovery story, they have become exhausted with trying to short it. Many have taken a similar posture as myself, waiting for confirmation of a move before committing capital to shorts or liquidating longs. Being a person constantly looking for contrary indicators, my own emotions and those of others typically provide clues to changes ahead. Perhaps this is one of those times...

It is a market driven by momentum. In talking with various colleagues, I try to get a handle of how much conviction buyers seem to have. I don't get the feeling that many of those holding substantial long positions would tolerate much of a decline before checking out. Where are the stops? A 10% market decline? If many are indeed acting under this sort of a mentality, a selling panic could easily ensue once this line is crossed.

But that is subject for another day. Today, we have a climbing market to chart. Other than a nasty underperformance this week in banks, transports and the nasdaq, we have not yet come close to satisfying the qualifications I am waiting for.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

The recent push from the early October low of 1019 has certainly been achieved with declining participation. See the divergence below:

The ratio of the Dow to the S&P seems to move contra-cyclically. The Dow underperformed on the way down and now outperforms. A divergence in ratios like this, as well as with the Nasdaq may provide a window to the market's internal happenings.

I'm also watching the ratio between the VIX and VXV. This monitors the premium/discount of 3 month volatility to that of the present. As future volatility gets sucked out of future option prices, the ratio falls. For months, option traders were willing to pay a premium for September or October options. Due to seasonality it seems that many had been forecasting a market turn by either of these months. With October expiry out of the way, any distortions this may have created may be free to resolve themselves.

I do find it interesting that such an enormous consensus exists in utter hatred for the USD. Nearly everyone has been sold the story that the Dollar is destined to soon become worthless. But what is really interesting is that this has occurred while the dollar index remains well above its prior lows. I am anticipating a sharp move higher one of these weeks that will trigger quite a bout of short covering.

Have a great week!

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