Candle Chart Signals Market Top

09/20/2012 7:00 am EST

Focus: STRATEGIES

Ryan Detrick

Senior Technical Strategist, Schaeffer's Investment Research, Inc.

Ryan Detrick of Schaeffer’s Research highlights a troubling candle pattern on the S&P 500 chart and another ETF chart that warrants caution if going long here.

After stellar gains the past few months, I'm seeing some signs we could be due for a break. Now, by no means does this mean we just made a major peak, as I still think the overall uptrend is firmly in place. In fact, my favorite reason to expect higher prices is the action in short interest, which still suggests there is plenty of room for this rally to run.

But as traders, it isn't our job to hope or pray for our overall stance to be right. We need to adapt and change quickly (even against our personal view) if the charts tell us to change. I can't tell you how many people are "mad" at this current rally because the Fed manufactured it, yet the charts were predicting a breakout to new highs months ago.

With that said, back in early June I was on Fox Business Network, and gave reasons to expect a surprise summer rally. Fortunately, that's played out perfectly. I did see some worries a few weeks ago, which didn't materialize as we broke out. Yet again, I'm seeing some near-term concerns here.

I like to use candlestick charts versus bar charts, as I feel they give me a much better feel for the actual action that occurred.

Taking a look at the SPDR S&P 500 ETF (SPY) on Friday, it formed a shooting star formation. This can be a bearish formation that suggests the near-term trend has simply exhausted itself. They tend to happen at the end of bull moves.

Also note how overbought its relative strength index (RSI) is, again, increasing the odds of some type of correction either in time or price.

chart
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Next: SPDR S&P Homebuilders ETF

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Another concern I have is the action in homebuilders. We've been very bullish housing, and have done very well with calls on various names from the group over the past few weeks.

Yet, looking at the SPDR S&P Homebuilders ETF(XHB) again, I see a rather ominous-looking chart pattern forming. This one is called a bearish engulfing pattern, and again suggests the bears are trying to take control after a good run higher. Given the run housing has had, some type of pullback or consolidation is more than warranted.

Again, check out how overbought the ETF is:

chart
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So be on your toes here, and if you have some profits from this summer rally, don't be greedy if things continue to weaken from here.

Overall, I don't expect much of a pullback, as hedge funds have totally missed the surge this summer, and they will be active buyers on any weakness. Still, the charts don't lie, and as of today I'm happy with the rally, but think playing some near-term defense makes a lot of sense.

Ryan Detrick is a contributor to Schaeffer’s Investment Research Trading Floor Blog.

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