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Have the Bulls Been Trapped?
07/25/2012 10:25 am EST
The technical health of the stock market has deteriorated and knowing the key technical levels will allow you to be better prepared for a further market correction.
The action in the stock market during Tuesday’s regular session was moderately constructive, as again stocks rebounded from the heavy early selling to close well off the day’s lows. The after-hours trading was dominated by Apple (AAPL) as their earnings miss pushed the stock 5% lower.
The stock index futures did turn around overnight and are trading above Tuesday’s day session close. This is a short-term positive, but the market internals, which had signaled a correction last Friday, have now turned more negative.
The Advance/Decline lines are now acting weaker than prices, a strong contrast to early June, when the A/D lines were leading prices higher. The completion of the bear flag formations in the major averages ends the “Bear Flag or Bear Trap?” debate I began a few weeks ago.
So if the bulls are now trapped on the long side, what kind of decline should investors prepare for? Let’s look at the likely technical scenarios for the coming weeks.
Chart Analysis: The daily chart of the NYSE Composite shows that it gapped through support (line c) on Monday’s opening. This completes the flag formation (lines b and c). Next support sits at 7,464, which was the June 26 low.
- The 61.8% Fibonacci retracement resistance had been tested in early July, and last week’s rally failed below these highs.
- The NYSE A/D line tested its prior highs last week before turning lower, and it has now broken its uptrend (line e).
- The A/D line has dropped below its prior lows, with next major support at line d, which was the late June low.
- The June 4 low at 7,222 is 4.8% below Tuesday’s close, with the 127.2% Fibonacci retracement target at 7,030.70.
- The A/D line needs to move above the resistance from its twin peaks to turn the outlook back to positive.
The chart of the Spyder Trust (SPY) shows that it closed below its support (line g) on Tuesday.
- The SPY is still above the July 12 lows at $132.60, with further support from June 25 at $130.85. A daily close below this level will be further sign of weakness.
- The S&P 500 A/D line has dropped below its previous lows (see circle) and more importantly is also now below the late June lows (line i). It is acting weaker than prices.
- Last Thursday, the A/D line formed a short-term negative divergence (see arrow) and then turned lower the next day.
- The high in the A/D line last week also failed below the long-term downtrend (line h) that goes back to the April-May highs.
- The bullish divergence support for the A/D line at the June lows (line j) is an important level to watch.
- The minimum downside targets for the SPY are in the $130 area, and a drop to the June low at $127.14 is a clear possibility.
- The major 50% retracement support from last fall’s low is at $124.82. Using the June low to last week’s highs, the 127.2% Fibonacci retracement support is at $123.94.
- For SPY, there is resistance now in the $135.25 to $136 area.
NEXT: How Low Will Tech and Small Caps Go?|pagebreak|
The Powershares QQQ Trust (QQQ) traded as low as $62 yesterday in response to the release of Apple’s earnings. This was well below the uptrend (line b), which was the lower boundary of the flag formation (lines a and b).
- There is next support at $61.86 and then $61.54, which was the June 28 low.
- QQQ dropped as low as $60.04 in early June, with the major 50% retracement support at $59.22.
- The 127.2% Fibonacci retracement target from the flag formation is at $58.53.
- The Nasdaq 100 A/D line has deteriorated in July, as it broke the downtrend (line c), in late June.
- The A/D line turned lower last week from its flat WMA, and shows a pattern of lower lows.
- The key support for the A/D line is at the June low (line d).
- There is first resistance now at $63 to $63.59 and the 20-day EMA.
The iShares Russell 2000 Index has been the weakest major market sector since the late March highs, even though it had a very sharp rally in late June, reaching a high of $61.86.
- The rally last week was not impressive, as IWM also gapped through support (line f) on Monday.
- There is next support at $75.42 to $74.78, and then $72.94, which was the early June low. This low was very close to the major 50% Fibonacci retracement support at $72.30.
- The 127.2% Fibonacci target from the flag formation is at $70.26
- The Russell 2000 A/D line tested its downtrend (line g) on July 5, but has now dropped well below its prior low and its WMA.
- A break of A/D line support (line h) would be more negative.
What it Means: The deterioration in the A/D lines increases the chances that some of the major averages will test the early June lows. Some are preparing for a collapse like last year, which would imply a drop well below the June lows. A test of the major 50% retracement support is possible.
Many things are different this year. Although the bearish sentiment is already quite high, the market in my view is stronger technically. Therefore, I would expect any break of the June lows to be well supported. It would take a break in the A/D lines below their June lows to turn me more negative.
Clearly the risk on the long side has increased. Use any market rally to reduce equity exposure, especially in those stocks that are acting weaker than the S&P 500.
How to Profit: I will be adjusting the positions in the Charts in Play Portfolio over the next few days, here as well as through Twitter postings, so keep an eye on @TradersExpo and @TomAspray.
Investors should be long the Spyder Trust (SPY) from $132.85. Use a stop at $132.48, and on a move above $135.10, raise the stop to $134.34.
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