Bulls Running—Don’t Get Trampled

04/29/2011 11:25 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Bullish sentiment is rising and the markets may continue higher in the short term, but investors must still be prepared to identify the signs of a correction and act quickly and decisively.

Since mid-March, there have been two distinct cases of what I called “panic selling,” as those who sold on the news quickly regretted their decision. Now that Ben Bernanke appears to have calmed investors, there are some early signs that we could be approaching a period of buying panic.

While the market internals for the broad market, such as the Advance/Decline (A/D) line, are still confirming the higher prices, some market sectors are starting to diverge on a short-term basis. These divergences could be resolved in just a few days of trading, however, and the major trend for the stock market remains positive.

Nevertheless, as we continue to move higher over the next few weeks and the major averages reach my next major price targets, investors would be prudent to adjust their strategies accordingly.

Typically, extremes in sentiment—both bullish and bearish—can build over several weeks, as was the case last summer when the number of bullish newsletter writers dropped below 30% by the end of August.

That number is now likely closer to 60%, and it sends a signal that investors should adopt a more risk-adverse buying strategy, take some profits on longs when prices are moving higher, and be sure that protective stops are adjusted as prices move up.

When the market does get a more severe correction in the next few months, you will be better prepared to buy when the risk is lower.

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Chart Analysis: The daily chart of the Spyder Trust (SPY) shows the convincing breakout above the major resistance, line a, that creates a strong band of support now in the $134 area. There is more important support at $130 with the rising 200-day moving average (MA) much lower at $122.

  • The next minor target for SPY is the 127.2% retracement level at $137.64

  • Starc bands are one tool I use to identify high- and low-risk levels to buy (for more, read “Buy, Sell, or Wait: A Way to Decide”). SPY is now just below the daily starc+ band, and the weekly starc+ band is now at $139.90. This corresponds to the psychological resistance level on the S&P 500 at 1400

  • The completion of the trading range gives upside targets in the $142.50-$145 area

  • The S&P 500 A/D line made new highs in early April, giving the bulls a clear signal that they should be buying on dips

  • The A/D line retested the breakout level, line c, on the panic selling in reaction to the S&P downgrade of US debt

The Diamonds Trust (DIA), which tracks the Dow Industrials, has accelerated to the upside this week and is not far below the trading channel resistance in the $129-$130 area.

  • DIA closed at the daily starc+ band on Thursday with the weekly starc+ band currently at $129.86

  • If the current rally in DIA is equal to the rally from the September 2010 lows to the November highs, we get an equality target (100%) for the current rally at $130.96

  • There is initial support now at $125-$125.60 and then more important support at $123.70-$124.40

  • The Dow Industrials A/D line has surged to the upside after overcoming the resistance at line g. The somewhat parabolic nature of the A/D line makes me a bit nervous for the short term

  • During the sharp selloff in the middle of March, the A/D line pulled back to test good support at line h

NEXT: Critical Warning Signs to Watch for

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There were quite a few headlines when the Nasdaq Composite surpassed its 2007 high of 2815, closing Thursday at 2872.50. Of course, market veterans will remember the all-time high in 2000 was at 5132.

  • The weekly starc+ band is not that far above current levels at 2972. The upside breakout on the daily chart (line a) has targets just above 3000 with the major 50% retracement resistance level is at 3131

  • Despite the impressive price action, the Nasdaq’s A/D line is still below both the February and April highs (line c). This could be resolved in the next week or so, but the former uptrend, line d, needs to be overcome to signal strength. It is well above current levels

  • The A/D line has key short-term support at line e, which, if violated, would be a sign of weakness

  • There is initial support now in the 2800 area and a break below 2700 would clearly be a short-term negative

The Russell 2000 was featured in a major Wall Street Journal headline on Thursday when it moved to new all-time highs, surpassing the July 2007 peak. The iShares Russell 2000 Index Fund (IWM) shows an impressive rally from the March lows, having gained almost 11%.

  • IWM has daily trend line resistance just above $87 with the upper boundary of the trading channel at $88.70. The weekly starc+ band is just above $90

  • Though RS analysis still shows that the small- and mid-caps are outperforming the S&P 500, the market internals on the Russell 2000 are lagging. The A/D line has not yet moved above the April highs and has trend line resistance at line i

  • The A/D line has important support now at the April lows

  • IWM has initial support now at $84.50 with additional support at $83.40. Key support on the daily chart is now at $81.40

What It Means: The increasing bullish sentiment and the lagging action of the Nasdaq Composite and Russell 2000 are good reasons to keep a close eye on the market. A simple way to gauge how the market has changed since last September when the A/D line was also breaking out to new highs is to look at the relationship of the SPY to its 200-day MA.

In September, the SPY was just below its 200-day MA, but it is now 11.5% above it. Though the market can still clearly move higher over the next few weeks, now is not the time to be getting greedy, as the odds have increased for a 3%-5% market correction by early in the summer.

How to Profit: If SPY reaches the $139-140 area or DIA approaches the $129.50-$130 area, I would advise raising some cash. Regular readers know that I routinely recommended selling half of a position at the first upside target because it is always easier to sell on strength than it is on weakness.

Clearly, stops should continue to be raised as your long positions move higher, and those familiar with options could consider hedging their positions by using a covered call strategy once the market reaches more formidable resistance.

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