Price Action Points to a Change in Market Direction

01/10/2011 11:27 am EST

Focus: STRATEGIES

With the holiday season now in the rearview mirror and volume slowly creeping back into the marketplace, I can’t help but wonder what lies ahead. The optimist in me is hopeful that the economy will continue to repair itself and the financial issues that plague federal, state, and local governments will just go away as the economy rebounds. The only problem with my hope is that massive debts and deficits do not simply disappear, and I fear the problems will be long lasting.

Federal Reserve chairman Ben Bernanke indicated that unemployment numbers are likely to remain stubbornly high for an extended period of time. He also made it clear that new quantitative easing (QEII) was necessary and needed to be continued in a vain attempt to keep interest rates low. Since its inception, Treasury rates have done nothing but increase, which begs the question of whether the program is really doing anything it was intended to do.

In addition to our domestic debt issues, unemployment claims, and the poor housing market, we find that the crisis in Europe, while somewhat muted, continues to manifest in a negative fashion. Nearly everywhere we look, we are surrounded by fundamental issues that directly impact risk assets. These issues have been constant for quite some time, and the S&P 500 has shrugged them off and powered higher. The S&P 500 has put on quite a run since the March 2009 lows, and while we have had several corrections and a “flash crash” along the way, we have yet to see a major correction turn into bearish market conditions.

Is price action last week an early warning sign that lower prices await us in the equities market? Is the US dollar going to breakout above the 50-period moving average and challenge the 83 price level on the weekly chart?



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If the resistance zone listed on the weekly chart failed, the dollar would seemingly be poised to test the triple tops around the 88-89 price level. A quadruple top is not a technical pattern that is recognized by many traders as the fourth mouse typically gets the cheese. The flip side would offer that if resistance around the 83 price level holds and the dollar plummets, risk assets would move higher. It is too early to tell what is going to happen, but active traders need to be monitoring the US dollar index closely, as it will provide clues as to the direction of the S&P 500 and gold.

S&P 500

Friday’s market action is indicative that lower prices may be awaiting us in the coming days and weeks. A reversal has been potentially carved out, but it remains to be seen if a top is in. Picking tops in a long-term bullish trend is a fool’s game because bullish advances can be overbought for long periods of time as they advance higher. What is evident is that prices are being pushed lower and strong selling volume is confirming the potential for a longer-term reversal. It is too early to tell if the price action is just working off overbought conditions, or if this is a change in price action and market direction. The daily chart of the SPX illustrates the possibility that a reversal or the potential for an intermediate-term top to be in.



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The S&P 500 has tested the first support area around 1,260, and it bounced, which is typical price action. The question will be whether price will drift higher the rest of the day and close modestly lower, or if selling pressure will hold prices down near the lows of the day. In the recent past, Friday morning selloffs led to a drift higher that by the sound of the closing bell, saw prices flat or only slightly lower. Would this be different?

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There are a few confirming signals that prices may continue lower. Recently, Fridays have had relatively low volatility and light volume with the propensity to grind higher through the afternoon session and into the close. While the grind higher remains to be seen, volatility is rising. The CBOE Volatility Index (VIX) is trading nearly 3% higher on the day and is around the 18 price level, as seen on the chart below. Price action remains at the upper bound of the lower channel. A breakout in the upper channel could result in additional selling pressure should that occur.



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Another telling sign that additional sales pressure may be lurking next week or in the near future is the price action in the financials. The Financial Select Sector SPDR (XLF) is currently trading down about 1.60% on the day and has completed a gap fill from last week. Price bounced, as is typical, but selling pressure remains strong. If the financials continue to probe lower in coming days and weeks, the S&P 500 will follow in suit. The daily chart of XLF is shown below.



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In the end, it is simply premature to determine what the price action taking place today in the S&P 500 will lead to. We could see a drift higher this afternoon back to near break-even, which has been common in the recent past. We could see prices consolidate at current levels, or we could see continuation selling with an intermediate-term top being put in. At this point, all we can do is wait and see what happens. As I have said before, adjusting stops and taking profits is likely a sound strategy until we know more regarding the price action in the S&P 500 next week.

Gold Futures

Most gold bugs are expecting an outright US dollar meltdown. What if they are wrong? If you ask them, the dollar is surely going to get destroyed, and our way of life and standard of living is set for major changes. I do not know for sure what is going to happen, but if the crowd says the dollar is sure to get killed, the contrarian trader in me wants to get long the dollar in a trade with a good risk/reward set-up and defined risk.

If we look at the gold futures, it is obvious that they are moving lower, and a serious correction could be taking place. If gold futures break down below the 1,330-1,315 support area, a full-fledged correction of 10% or more could take place. The next major support level in gold futures would be around the 1,250 area. The daily chart of gold futures illustrates the key price levels that are currently in play.



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Gold has already pulled back quite a bit from the recent highs, but time will tell how deep the pullback in the shiny metal will be. At first glance, I would expect more carnage here simply because of how bullish the retail crowd is regarding gold. Longer term, gold will likely remain in a bull market, but for those who took profits and have waited patiently, gold could give us a solid risk/reward entry. The traders and investors who purchased above the $1,400-an-ounce price point have either stopped out or their money is currently trapped. If prices go low enough, those trapped traders will eventually capitulate near the lows. If history serves us well, just about the time the last remaining weak gold bull gives up will be right around the intermediate-term bottom.

It’s hard to say what is going to happen the rest of this week, but based on the price action last week, it is going to be anything but ordinary. At this point, I do not have a clear edge as to what is going to happen in the S&P 500 or gold. What I do know is that they are both under fire, and the confirming signals in the VIX and financials are worthy of note. While I will not be jumping into either asset class with fresh capital, I will be watching closely to see if a low-risk set-up presents itself. Instead of trading based on a feel, a prediction, or a bias, I intend to patiently wait to see what transpires in the next week before putting any capital at risk.

By J.W. Jones of OptionsTradingSignals.com

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