Technical Studies Warn of Market Drop

09/21/2011 10:05 am EST

Focus: STOCKS

Thomas Aspray

, Professional Trader & Analyst

With several key warning signs showing up on the charts, risk is high for new buying, and more favorable entry points are likely coming soon for the major stock index ETFs.

Stocks gave up their early gains on Tuesday, and the reversal was the most pronounced in the tech-heavy Nasdaq Composite. The stock index futures are lower in early-Wednesday trading and the markets may be quiet going into the widely anticipated Federal Open Market Committee (FOMC) announcement this afternoon.

Overseas markets were mostly lower and the short-term technical studies do suggest that the rally has stalled. The weak action in crude oil is also a concern. As I pointed out a few weeks ago, there is a nice correlation between crude oil prices and the S&P 500. The November crude oil has turned lower over the past few days and volume has increased on the decline. A break below the support at $83.40 should trigger heavier selling.

Of course, a rally to stronger resistance in the $125-$127 level in the Spyder Trust (SPY) is still possible, especially with the FOMC announcement, but the risk on the downside does seem higher.

The most negative interpretation is that the entire rally from the August lows is just a bear flag which will be followed by a drop to and/or below the August lows.

An alternative interpretation is that we will see a “soft landing,” which implies a decline to the $112-$115 area in SPY. This is consistent with both the improvement in the Advance/Decline (A/D) line and also the increase in bearish sentiment.

Another drop would help to increase the level of pessimism, which is needed to fuel a more sustainable rally. Let’s look at the evidence.

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Chart Analysis: The daily chart of the Spyder Trust (SPY) shows Tuesday’s failed rally attempt. There is next support in the $116.70-$118 area with the lower boundary of the flag formation, line b, in the $115 area.

  • A close below last week’s low at $114.05 is likely to trigger heavier selling with the August lows at $110.27
  • The 127.2% Fibonacci retracement target is now at $106.50
  • The McClellan Oscillator formed significantly lower highs on the last rally and has turned down. It is now back below the zero line and a break of support at line c will signal a further decline
  • There is initial resistance for SPY now at $122-$123.40

The daily chart of the Nasdaq Composite shows that it has had a much more dramatic rally from the August lows, as it has surpassed the 50% retracement resistance at 2608.

  • The upper boundary of the flag formation, line d, is at 2664 with the 61.8% Fibonacci retracement resistance at 2678.
  • The McClellan Oscillator has formed a negative divergence at the recent highs, line f. It has now dropped back below the zero line and a break of support at line g would confirm the divergence
  • There is initial support at 2550 with the lower support from the flag formation (lines d and e) in the 2490 area
  • There is a potential double bottom on the charts in the 2330 area

NEXT: More Ominous Signs for Stocks; How to Profit

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The PowerShares QQQ Trust (QQQ), which tracks the Nasdaq 100 Index, exceeded the upper resistance from the flag formation on Tuesday (line a), but then closed lower, which is a short-term negative. The 61.8% retracement resistance at $55.88 was decisively overcome on the recent rally, which was a positive sign.

  • Initial support is now at $55.30 with further support at $54.60. The uptrend, line b, is in the $53.50 area
  • It would take a close below the September 6 lows at $51.91 to signal a test of the August lows
  • The Nasdaq 100 A/D line overcame its downtrend, line c, last week, which suggests the A/D line may be bottoming
  • The A/D line numbers on a decline will be important, as the September lows in the A/D line need to hold to set the stage for a new uptrend
  • There is major A/D line support at the August lows
  • There is resistance for QQQ at $57.35-$58.00

The iShares Russell 2000 Index Fund (IWM) continues to act the weakest, as the recent rally peaked at $72.03, well below the prior high at $73.89.

  • The uptrend from the lows, line d, is now at $66.40 with additional support at $64.57
  • The A/D line on the Russell 2000 looks the most ominous, as it made lower lows last week, line f. The down-trending channel (lines e and f) is a sign of a weak market
  • It would take a move above the prior peak and a break of the downtrend to turn the A/D line positive

What It Means: The short-term technical outlook shows signs of deterioration, and while that does not mean that stocks have to drop immediately, it does mean that a further rally should be carefully watched.

More importantly, it suggests that those who are looking to buy stocks or ETFs should be able to buy lower, and the tech sector is still my favorite destination for new buying. I favor the “soft-landing” scenario but will be watching the market internals closely.

How to Profit: If you did not lighten up on the weak stocks in your portfolio when SPY reached the $121-$122 area, I would not wait any longer.

For those looking to hedge, selling options against existing positions looks most favorable, or else consider an option spread strategy since put premiums are high.

Alternatively, traders could buy the ProShares Short S&P 500 ETF (SH) at $43.36 or better with a stop at $41.72 (risk of approx. 3.7%). Sell half the position at $45.56 and raise the stop on the remaining position to $42.88.

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