Market Timing 101

05/19/2011 2:40 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Traders can use divergence analysis and proven indicators like the Advance/Decline Line to identify critical market turning points—like the one that seems to be unfolding this week.

For most veteran analysts, technical analysis is part science and part art, as the indicator patterns require some subjective analysis. In timing the stock market, there are a series of tools that I use to determine whether or not the market is healthy. As we approach the summer months, which is often a difficult period for stocks (think “Sell in May and go away”), I like to keep an even closer eye on the market’s health.

I have been using divergence analysis for over 25 years and determined early on that relying on divergences in just one time period was dangerous. On the other hand, significant turning points often coincided with weekly divergences that were then confirmed by the daily analysis.

This is rarely pointed out in the current trading world, as some analysts have concluded that divergence analysis doesn’t work based on their analysis of only the daily data. Others who do believe in divergence analysis can often come to the wrong conclusions when they look at divergences in only one time frame.

One of the most powerful tools for market timing is the divergences that occur between the Advance/Decline, or A/D line, and the major stock market averages. Let’s first look at the weekly NYSE A/D line.

Figure 1

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In the above chart, I have combined the weekly NYSE Composite A/D line and that of the Spyder Trust (SPY), which is more familiar to most traders than the NYSE Composite. I am continuously monitoring the relationship of both averages to the A/D indicators, but over the years, I have found the signals to be essentially identical.

At the late-April 2010 highs, the weekly A/D line failed to make new highs with SPY, therefore forming a negative divergence, line c. The following week, the A/D line violated its uptrend, line d, confirming that a trading top had been completed. Though the daily A/D line will generally form a divergence at the same time, it did not form such a divergence at the April 2010 highs.

The weekly A/D line declined for the next five weeks, bottoming in early June (point 1) while the SPY made its low five weeks later at point 2. The higher low in the weekly A/D line (point 2) was a bullish divergence that was confirmed when the downtrend in the A/D line was overcome (line c).

The A/D line broke out to new highs during the first week of September, as it was acting much stronger than prices. This was a very bullish development. Several days later, the daily A/D line also broke out to new highs. (See “Advance/Decline Line Hits New High.”)

The A/D line’s major uptrend from the lows, line e, is still intact. The weekly A/D line only had a minor pullback in mid-March when global markets reacted to the disaster in Japan. This was a sign of strength and helped convince me at the time that the decline would not last long.

Earlier this month, the A/D line made another new high, but it turned lower last week. Since the weekly A/D line has confirmed the most recent highs, there are no signs yet of a top, but one could still form before the end of the month if the A/D numbers do not keep pace with prices.

NEXT: Analyze Latest Chart Action for S&P 500

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Figure 2

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The daily chart of the Spyder Trust (SPY) shows a fairly orderly A-B-C corrective pattern that appears to have been completed on Tuesday, May 17. SPY partially filled its April gap on the recent correction and nearly reached its equality price target. It held well above the longer-term uptrend, line b, but did briefly violate the short-term uptrend (line c) this week.

The daily A/D line (updated through May 18) has now turned up, as it held above both its weighted moving average (WMA) and the prior low on the recent correction. The daily A/D line made a new high on May 10.

The McClellan Oscillator is generally a pretty good tool for identifying short-term peaks and valleys, but it was not as useful in early 2011. The short-term negative divergence at the early-May highs, line e, did help alert us to the recent decline. It reached moderately oversold levels of -150 on Tuesday before turning up, which is a moderately oversold level Wednesday and should now rally at least back to the +200 area. Often, it is the crossing of the zero line that precedes a more dramatic move.

Figure 3

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I also use the number of stocks making new highs or new lows to measure the health of the stock market, but I only use it in conjunction with the A/D analysis. In a bull market, the number of new highs should expand as the market moves higher and confirm the price action. The number of new highs formed a series of divergences leading up to the completion of the major top in 2007. (See “Using Market Internals to Time the Market.”) Of course, in a bear market, the new lows will expand as the market moves lower, but will generally diverge as the market bottoms.

The daily chart of the NYSE Composite reveals that the major support lies in the 7880 area (line b), which was tested in March. The parallel trading channel has support at 8170 (line c) and resistance at 8950, line a. This is about 7% above current levels.

The number of stocks making new lows has risen gradually, line d, but has still not surpassed the March peak of 26. The number of new lows hit 150 several times last summer, and this is a more important level to monitor.

The number of new highs on the NYSE peaked at 647 in April 2010 and has since formed a series of lower highs, line d. At the May 2010 highs, the number of stocks making new highs was only 232, well below the November peak of 539.

Though it is tempting to try to find some market aberration to explain this action, I prefer to take it at face value. If divergences develop in the A/D indicators, or if there is an expansion of the number of new lows, it will become a stronger warning signal.

NEXT: Important Trends in Nasdaq 100 and Russell 2000

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Figure 4

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The PowerShares QQQ Trust (QQQ) briefly violated its former downtrend (line b) on Tuesday before closing above it and continued higher on Wednesday. This suggests that the correction is likely over. The upper boundary of the trading channel, line a, is now just above $60. The 127.2% retracement target using the February-to-March decline is now at $60.61, and there is initial support now at $56.98-$57.50.

Recently, TradeStation.com put together an exciting data series that allows users to monitor the A/D numbers on many of the other market averages. This promises to be a valuable tool for determining sector allocation.

The Nasdaq 100 A/D line made convincing new highs in early May (line d) before the recent correction took it below the short-term uptrend, line e, on Tuesday. The A/D line turned up with Wednesday’s action, which is consistent with a resumption of the uptrend. There is more important support for the A/D line at line f.

The weakest part of the stock market since the April highs has been the small caps, as the iShares Russell 2000 Index Fund (IWM) reversed sharply from the April 13 highs at $86.81 and made a much lower peak in early May, unlike most of the other major averages. Tuesday’s low at $81.40 tested the daily uptrend, line g, and IWM was able to rally further on Wednesday. There is next resistance at $85.54, and a daily close above this level should signal a test of the highs.

The Russell 2000 A/D line formed a negative divergence at the April highs, line i, and violated short-term support (line j) this week. It regained this level on Wednesday, but nevertheless, the divergence pattern is still a reason for concern. I will be watching it closely, as the A/D numbers will have to be very strong to take the A/D line above the early-April highs.

This week’s action in the US stock market likely marks a short-term turning point that should set the stage for a move to—and likely above—the May highs. There is technical and psychological resistance for the S&P 500 at 1385-1400, and for the Dow Industrials, resistance is at 13,000-13,300.

Of course, if the major averages drop below the lows from Tuesday, May 17, it will indicate that the stock market's correction is not yet over.

Tom Aspray, professional trader and analyst, serves as senior editor for MoneyShow.com. The views expressed here are his own. Readers can post questions or feedback in the comments area below or send to TomAspray@MoneyShow.com.

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