There were a number of technical divergences today that setup the conditions for a short-term bottom in the market. Whether the setup holds or not will be determined by the price action of the indices over the next day or so. Here are some of the “tells” I saw on the tape today that didn’t cause me to panic in the morning. The afternoon rally has served to further confirm these hunches.
Market Morning Divergences
In the morning, the tape looked pretty ugly with consumer discretionary stocks leading the market to the downside. As I mentioned last week, this has been an area of strength for the market. The setup was there on deeply overbought weekly charts I sent last week. Ok, so the market looked ugly this morning and 1358 was being taken out. Yet even with the breakdown of support, there were some divergences to give me pause to doubt such a move.
Divergence #1
For starters, the futures market did not break down today. The S&P E-mini did not break yesterday’s low of 1342.50. Instead the low held and the futures rallied. More importantly the 1332 March low, another area of significant support, held—all while the S&P cash market broke support.
Source: TradeStation
Divergence #2
Like Tom Smith CFA has been mentioning with respect to divergences, we take note when only one or a couple of indexes break support/resistance levels but not all of the indexes. So when we say that only the S&P 500 and the Nasdaq Composite broke support while the Dow Jones Industrial Average and the Russell 2000 are holding, then there’s the possibility we get treated to a rally or correction. This morning was such a case.
The critical supports Tom gave were 1356/12,700/2945/782 for the S&P 500, Dow Industrials, NASDAQ, and Russell 2000, respectively. Today some of those levels were breached in the morning, but not all of them. This was an indication that we might get treated to a rally.
Divergence #3
The volatility index (VIX) is another gauge of the risk off trade. It is well off the March low, but it hasn’t broken out above 21.10 while the S&P 500 broke support today. That was a divergence.
Source: StockCharts
Oversold Indications
In addition to the three major divergences I noted above, there were some other signs that were technically significant and point toward the potential here for a rally. Starting off with some momentum indicators:
TRIN
If you follow TRIN, a mathematical formula that looks at advancing versus declining issues as well as advancing versus declining volume, what you need to know is that the indicator points towards oversold conditions when it reaches 3. It’s not a perfect indicator. Sometimes I saw TRIN values above 3 at the beginning of corrections last year, but often you find it at the end as shown below.
Source: StockCharts
Elliott Wave Count
Not many investors understand Elliott Wave nor do they follow it. It’s merely a labeling method for understanding the ebb and flow of the markets which oftentimes respects certain principles that govern Elliott Wave. Regardless of its personal value to you, the reader, it is a technical tool I often use to gauge how the market is behaving. The market tends to advance (2 steps) in the direction of trend and then backfill (1 step back) to take a breather. If it backfills more than just 1 step, basically, you have a change in the flow of the market.
Since March, I had estimated we would see a 5% wave (4) correction that would consolidate the S&P 500 trend from the October low. So far, this has been the case and why I remain bullish for the long-term. In addition, logical support levels near 1340 have held for this consolidation (today’s low was 1347 on the S&P 500).
Source: StockCharts
The intraday count this morning suggested to me that this correction looks done and done. A typical ABC correction has taken place. If my wave (4) count is to hold, then we should be starting the next leg higher in the stock market, wave (5). For that to hold, 1340 must hold. If it doesn’t, then we will have a more serious leg to the downside under 1340, possibly testing 1290, which is my target if the S&P 500 creates a double top formation.
The intraday setup this morning led me to believe that this correction is likely done.
Source: StockCharts
Hammer Time
Before I even began to specialize in technical analysis, I understood the significance of the hammer candlestick. It was one of the most important signals I watched for when I wanted to buy a stock or time a bottom in the market. A hammer candlestick shows up when the bulls take back control from the bears. It is defined as a candlestick with a long lower shadow that is at least twice as big as the body, typically found at bottoms. The color of the candle isn’t important.
As I always like to reference Steve Nison’s book, Japanese Candlestick Charting Techniques, the Japanese word for hammer is Takuri which means “trying to gauge the depth of the water by feeling for its bottom.” Imagine the bears jumping off a diving board, splashing through water support, and then touching the 11’ depth of the deep end. Then the bullish forces push hard off the bottom and surface the diver above water. The market can breathe now! They just hammered out the bottom - Takuri.
The intraday rally from 1347 back up to the close at 1363.72 further served to signal that a rally may be in store for the market. Such an intraday reversal shows up in candlesticks and creates the bullish “hammer”. The pattern needs follow through tomorrow to confirm the pattern, but it’s another bullish setup in the chart today.
Risk Off
Despite the correction in risk assets over the past 5 days, the dollar hasn’t broken out in true risk off fashion. The dollar is holding below 80 resistance and is still well off the January high. No breakout in the dollar means no breakout in risk off trade to me.
Final Thoughts
The market should be treated to a rally from here but there are some concerns now after a month or two of sideways action. Unless we get some sort of new catalyst for the markets, the technical picture has deteriorated from the early April high. The market internals actually started to turn mid-March after disappointing manufacturing data from Europe and China. Some of the commodities and global growth stories began suffering. Last week, Europe again disappointed with the PMI figures. The one technical indicator I watch for long-term moves in the market is the percentage of stocks in the S&P 500 above the 200-day moving average. You can find it on StockCharts.com and it looks like this:
When you see this indicator drop below 70%, it’s a sign that market internals are deteriorating. Less stocks are participating on up moves and the market is becoming more selective. StockCharts doesn’t show it here, but on my TradeStation quote system, this figure fell to a low of 65.59% near the lows. That’s a long-term sell signal, but it did close back to 70.62% in TradeStation’s data. It definitely causes some worry going forward.
Finally, if we do plan a final leg up for the October rally, correlations will continue to drop and fewer stocks will participate. Some may have already hit their highs for the year when the S&P hit 1422. So be selective in what you own. Be disciplined with trading sell stops. It’s especially important to begin thinking about risk control while holding on to stocks that have acted well despite the 5% correction in the S&P 500. Maybe even diverting more cash to those areas.
