When Is a Breakout Not a Breakout?

04/17/2013 6:00 am EST

Focus: MARKETS

Greg Capra

Co-Founder, MasterTrader.com

A breakout occurs when prices are able to clear a prior price area that has previously been a point of resistance, but not all breakouts are the same, and this one in particular could be treacherous, notes Greg Capra of Pristine Capital Holdings, Inc.

Last week, the broader markets broke out above their current resistance areas and S&P 500 finally joined the all-time high list. With no area of prior price resistance above, it's safe to assume the markets will continue their march to higher levels. Finally, mutual fund investors that bought into the market at the highs in 2000 or 2007 and suffered long through 50% decreases and slow recoveries will see a gain on their investment. Happy times are here again!!! Hold on a sec., it's not that easy.

As students of the markets and educated investors, swing traders or day traders, we don't assume anything. Following the trend is the simplest approach there is, and it works. However, human nature being what it is, without an objective method of determining the underlining strength or weakness and sentiment of the markets, we are more likely to ignore or rationalize the warning signs of change or the actual trend change itself when it comes. Of course, this assumes you have a method of doing that. 

I have seen enough trending markets to know that they always go further than you think they will. They continue their move until they have wrung out the last few doubters, and I think the markets now will do that with this uptrend as well.

An example of a trend that moved beyond what the majorities believe was possible is Apple (AAPL). It moved from 100 a share to 300, 400, 500, and then 600! The doubters were wrung out. At 700 there were few that doubted it wasn't going higher. Then when the turning point came; well, it's a temporary stall. It will be back to new highs shortly. Maybe it will at some point, but AAPL is now down 40% from its all-time high and still showing relative weakness to the broader markets.

The greed and fear that comes with being human cannot be stopped. AAPL investors are realizing this now, but with better education, you can empower yourself to overcome that human fault as it relates to investing your money in the markets. Here is what I am looking at now to guide me about the recent move higher in the broader markets.

NEXT PAGE: Concerning Market Divergences

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Chart of ETFs and Internals
In the below chart, I've put together four market index ETFs. The S&P 500 ETF (SPY), the Nasdaq 100 (QQQ), the Transportation index (IYT), and the Russell 2000 index (IWM). I also have two market internal gauges. The McClellan oscillator, which is a measure of market breadth and a put/call ratio with a five-period moving average of its closes.

We have many markets that have made all-time highs (not shown other than SPY) or have broken out above resistance like the Nasdaq 100. However, IYT did not move to new all-time highs with the recent move higher and is under its resistance. IWM also could not move to all-time highs and is under its resistance area. Historically, these two indices not confirming have been warning signs of underling weakness that preceded a market correction.

chart
Click to Enlarge

It's too early to say these two indices will not move higher above their respective resistance areas, but should they establish lower highs and move toward their recent prior lows, it will be a bearish signal. If they move above their resistance areas, it's happy days-onward and upward!

The internal gauges shown here are neutral. The McClellan is near zero and the 5-MA of the put/call ratio is in the middle of the range, so no guidance there of a turning point. However, those typical "wrong-way" option traders immediately jumped to buying puts (bearish bets) Friday. This is a short-term bullish sign that supports the breakout last week in SPY and QQQ and a continuation of that strength last week.

That strength was not confirmed by all indices, so we have divergences that are concerning. However, with option traders that are historically wrong and betting that the markets will move lower, the divergences are offset by those excessive bearish bets. With this, I'll be neutral over the next few days, but siding with the breakout to continue higher.

By Greg Capra, President & CEO, Pristine Capital Holdings, Inc.

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