Why Panic Sellers Could Be Sorry

02/24/2011 3:15 pm EST

Focus: STOCKS

Thomas Aspray

, Professional Trader & Analyst

Fear is on the rise and stocks are falling fast, but before heading for the sidelines, take a look at the market internals, which show that the mid-term trend is still bullish.

The prevailing mood on Wall Street has had a dramatic shift in the last week as concerns over too much complacency have been replaced by a high degree of investor fear in just two days of trading. If we look at the recent trading in some individual stocks, we might conclude that longs are being dumped at any price. Though it is likely to take some time before last week’s highs are exceeded, there are no signs from the market internals that the stock market has made a major top. Therefore, I would expect that some investors will have “seller’s remorse” in the next few weeks. Instead of focusing on the technology sector this week, I decided to discuss the technical status of the stock market so that nervous investors and traders might gain a better idea of what to expect.

Historically, intermediate-term declines in the stock market have been forecast in advance by the Advance/Decline (A/D) line. This is a running total of advancing issues minus declining issues. On the most basic level, one should watch whether the A/D line for a market average is making a new high when the market average makes a new high. This is often referred to as a confirmed new high, which establishes that the current trend will continue. For example, in October 2007, the new highs in the major market averages were not confirmed by the A/D lines, which had already topped out, and this provided a strong warning sign that the trend had changed.

Figure 1


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Figure 1 above shows the weekly chart of the S&P 500 and plots the weekly A/D line for the NYSE underneath. The NYSE Composite is a broader measure of the stock market, but it is less familiar to most than the S&P 500. In the summer of 2008, the weekly A/D line bottomed. As the major averages like the S&P 500 continued to make lower lows in the latter part of 2008 and early 2009, the A/D line was forming a series of higher lows, line d. This positive divergence made it very unlikely that stocks were going to collapse in March 2009. While the weekly A/D line peaked in September 2009 and formed a lower high in April 2010, the daily A/D line continued to make new highs with prices.  Both the weekly (line c) and daily A/D line (click for chart) moved through resistance in late August and early-September 2010, providing a very positive signal for stocks.

By the middle of September, the weekly A/D line was already making new highs and was rising sharply. A trading range developed in the weekly A/D line towards the end of the year, but this was recently resolved as it surged to new highs. This is a very positive sign for the intermediate-term trend. The first support to watch for the weekly A/D line is at line b, and if this level were broken, it would indicate a deeper correction.

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Figure 2


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Both the Dow Industrials and Nasdaq 100 have been hit hard in the past two days, and now, courtesy of Tradestation.com, we are able to look at the A/D lines for these two market averages. I am using the ETFs that are based on these averages since they should be more relevant to both traders and investors.

The daily uptrend in the Spyder Diamond Trust (DIA) was broken during Wednesday’s session (Feb. 23), but DIA did not violate it on a closing basis. The minor 23.6% support level using the rally from the November lows is at $120.20. There is converging Fibonacci retracement support now in the $118 area, while the major 38.2% support level from last summer’s lows is at $114.24. This also corresponds to the chart support from the November 2010 highs. The A/D line confirmed the new highs in DIA last week, and although it is now declining, it is still well above its uptrend, line c. The November highs (line b) represent key support for the Dow’s A/D line.

The Powershares QQQ Trust (QQQQ) has been hit with heavy selling this week and is now approaching the first band of chart support in the $56-$55.40 area. The 38.2% retracement support from the August lows is at $52.89 with the 50% support at $51. The Nasdaq 100 A/D line made significant new highs last week but could drop to test first support (line e) by the end of the week. There is more significant support for the A/D line at the uptrend, line f.

Figure 3


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The iShares Russell 2000 Trust (IWM) reached the upper trading channel, line a, before reversing sharply. It is already back to first support in the $79.40 area with the uptrend (line b) now at $77. The 38.2% support and the November highs are in the $74.30 area. Unlike the other major averages, the A/D line for the Russell 2000 just made marginal new highs last week. It is already testing its uptrend (line c), which is likely to be broken over the next few days. The more important support is at the November highs, and we will be watching closely to see if the A/D line forms a pattern of lower highs and lower lows.

The Spyder Trust (SPY) has already dropped back to the 130 level and reached the lower daily starc band (not shown). As I have discussed in the past, this increases the odds of a bounce or at least some sideways trading over the new few sessions. The minor 38.2% support from the November lows is at $127 with the 38.2% support level from the August lows at $123. This also corresponds to the strong chart support from the November highs. The A/D line made significant new highs in the past week before turning lower. If the uptrend, line e, is broken there is additional support at line d and the January highs.

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Figure 4


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The only cautionary note from the intermediate-term analysis of the market internals is the action of the number of issues making new highs on the NYSE Composite. That number peaked at 647 in April and only reached 539 last November. This series of lower highs (line d) could be explained by the recent decline in the bond market, as bonds are also included in this data. It is positive that the number of issues making new lows has not expanded sharply on the recent heavy selling. It has risen slightly to 24, but is well above the +150 levels that were recorded last summer. The uptrend on the daily chart of the NYSE Composite is at 8067, about 2.7% below current levels, with more important support going back to April 2010 at 7850.

Figure 5


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The short-term A/D indicators are just slightly oversold, which does allow for more selling over the next few weeks. The McClellan Oscillator has not given many strong signals since November, when it dropped close to the -300 level, point 2. Given the relentless nature of the rally over the past few months and relatively few wide swings in the A/D numbers, this is not surprising. At correction lows, the McClellan Oscillator will often drop as low as -250 to –300. It hit a low of -420 last May (point 1). Though it is still much too early, I will watch to see if any short-term positive divergences are formed that will help us identify the end of the correction.

Even though the global uncertainty adds another dimension to the recent decline, the intermediate-term outlook for the stock market remains positive. Though not featured in this article, the recent highs in the major averages were also confirmed by the weekly on-balance volume (OBV), which is also quite a reliable indicator.

So what should investors do? Be sure that you have judiciously placed stops on your positions and realize that the current decline is likely to provide some good buying opportunities in stocks that hold above important support levels. Of course, these stops should have already been in place before the market turned lower.

For traders, a rebound is likely in the next week or so that should retrace 38.2% to 50% of the recent decline. Such a rally will likely be followed by at least one more push to the downside and potentially a break of the prior low.

Tom Aspray, professional trader and analyst, serves as senior editor for MoneyShow.com. The views expressed here are his own.

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