Fasten Your Seatbelts

05/11/2011 5:33 pm EST

Focus: COMMODITIES

Thomas Aspray

, Professional Trader & Analyst

Today's corrections have turned the outlook for the markets almost upside down, at least in the short term. A big rally will be needed tomorrow or Friday to get the uptrend back on track.

The sharp reversal in the crude oil and stock market has weakened the short-term outlook for both markets.

Though the stock market in particular has done everything to surprise us on the upside, I am seeing similar short-term chart formations in both commodities and stocks that suggest the current decline will continue.

The key support levels to watch are the lows we made last week. If we can hold these levels tomorrow, we can keep the short-term uptrend intact. If not, than we are likely to see a drop back to—and possibly below—the April lows.

The good news is that the S&P A/D line did make new highs this week, so after a correction the stock markets’ overall uptrend should resume. On the other hand, the failure of the Russell 2000 A/D line to move above the early April highs favors further weakness. Let’s look at the charts.

chart
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Chart Analysis: The daily chart of the Spyder Trust (SPY) shows a three-day rally back to resistance at $136 before today’s reversal. It is often the case that technically weak rallies only last 2-3 days.

  • The SPY has key short-term support now at $133.02, which if broken makes a decline to the April lows at $129.51 quite likely. This also corresponds to the daily uptrend (line c)
  • The 200-day MA is much lower, at $123.30
  • The S&P 500 A/D line made new highs Monday (line d), which is positive for the intermediate term
  • A break of the A/D line’s short-term uptrend will confirm a further decline. Longer-term support for the A/D line can be found at the April lows and then the uptrend (line f).

The weak relative action of the iShares Russell 2000 (IWM) has concerned me for several weeks, and for the first time this year its A/D line has failed to confirm the new price highs.

  • IWM made a new high at $86.81 on May 2 before reversing to a low of $82.41 last week. This is now the key level to watch, and if it is broken the next support is at $81.43
  • The A/D line did form a lower high in early May, and has now turned lower.
  • If the A/D breaks last week’s lows, it will develop a pattern of lower lows and lower highs, which is consistent with a further decline.
  • Longer-term support for the A/D line sits at the uptrend (line i) and the March lows.

What it Means: The decline in crude oil does not appear to be over, and it is likely to drag stocks lower. The CME Group (CME) raised the margin requirements on the RBOB Gasoline Futures contract after the close, which will add further selling pressure.

The energy stocks are weighing down the market, as the Energy Select Spyder (XLE) tested key support at $73.58 today. A drop below $72.90 would be even more negative.

If the market is going to turn around, stocks need to mount a very powerful rally tomorrow or Friday. However, with new inflation numbers out both days, that may be tough.

How to Profit: Protecting profits is likely to be more important over the next week or so. One wants to avoid selling in a panic if the landslide becomes worse, which it may.

Several weeks ago I wrote Bulls Running—Don’t Get Trampled, where I recommended: “Clearly, stops should continue to be raised as your long positions move higher.”

I hope you did—it’s important to determine your stops when the market is not trading.

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