USING ADX LINE TO SPOT A TOP -- ENERGY BPI REACHES 92 -- FIFTH UPLEG IN BULL MARKET IS LED BY MATERIALS AND ENERGY
USING PARABOLIC STOPS IN AN OVERBOUGHT OIL MARKET... Yesterday I talked about using the Parabolic SAR dots to keep a tight protective sell stop in a rising but overbought energy sector. This sensitive trend-following system works best when a market like oil is in a strong uptrend -- as it is now. As of today, the SAR stop point is at 35.34 in the Energy Select Sector SPDR shown in Chart 1. The price of the ETF has to drop to the highest SAR dot to trigger a short-term sell (profit-taking) signal. But first a word on the 14-day RSI line itself. The oscillator is still in overbought territory over 70. That can go on for sometime. One way to tell if a trend is slowing is when the RSI line falls back under 70. A decisive drop under 70 will be an early indication of at least a short-term top. There's another indicator that can be used with the RSI and Parabolic systems.
Chart 1
USING DIRECTIONAL LINES TO SPOT A TREND... The three lines plotted below the price chart are useful technical indicators. They can be found under Stockcharts Indicator Windows by clicking on Wilder's DMI (ADX). Welles Wilder invented the RSI, Parabolic, and DMI (ADX) systems. That's why they work so well together. Also, the RSI and the DMI (ADX) lines are based on the same 14-day time period. The red and green lines are the Directional Indicator (DI) lines. The green line (+DI) measures buying pressure over the last 14 days. The red line (-DI) measures selling pressure. A buy signal is given when the green line crosses over the red line which happened at the end of August (see green arrow). An uptrend remains in effect as long as the green line stays over the red line. The value of the DI lines is that they keep traders on the right side of the market which, in the case of oil, is up. The third (black) line is the Average Directional Index (ADX) line and is meant to be used with the two DI lines.
Chart 2
USING THE ADX LINE TO SPOT TOPS... The ADX line is essentially the difference between the two DI lines. When the ADX line is rising, it means that a trending market is in effect. A trending market dictates heavier reliance on trend-following indicators line moving averages or Parabolic SARs. [A falling ADX lines suggests the absence of a short-term trend and greater reliance on overbought-oversold oscillators like RSI]. As long as the ADX line is rising, overbought readings have less meaning. It's when the ADX line starts to drop that overbought oscillator readings take on more meaning. There's more. One sign of an overextended market is when the black ADX line crosses over the green (DI) line. That tells us that the short-term uptrend is reaching a mature stage. An ADX reading over 50 is another warning signal. As of today, the ADX line is at 45 and has moved slightly over the +DI line. The real clincher, however, is when the ADX line starts to drop. That usually only happens when the two DI lines start to converge. So far they're still diverging, which means that the green line is still rising and the red line is still falling. The three lines are reaching over-extended territory, but haven't given a profit-taking signal yet. A downturn in the ADX line with an RSI reading over 70 is a dangerous combination. The preceding explanation is for those with a short-term horizon or who are looking to take some energy profits on the first sign of weakness. Those with a longer range horizon may find this indicator too sensitive for their needs. Long-term investors might want to use a weekly version of these indicators (which is less sensitive) or wait for the DI lines to cross into negative alignment before doing some selling.
ENERGY BPI INDEX REACHES 92... A couple of days back I wrote about the Energy Bullish Percent Index reaching very overbought territory at 90. As of today, the value has risen to 92. That means that a 6% decline to 86% is now needed to signal a possible energy correction. The BPI is the percent of stocks in a group that are on point & figure buy signals.
Chart 3
ENERGY DOES LEAD FIFTH WAVE ADVANCE ... I recently wrote about my expectation for a fifth and final upleg that should end the cyclical bull market that started in October 2002. I suggested that the most likely time for that to occur was between October and January. One of our readers asked if it's true that basic material and energy stocks usually lead the market during a fifth and final upleg. The answer is yes. Page 110 of my book on Intermarket Analysis shows a diagram of how market sectors perform during a typical business cycle. In the late expansion phase, the two top sector performers are basic materials and energy. That's usually associated with rising commodity prices, which lead to rising inflation expectations and higher interest rates. The fifth wave is also accompanied by the Fed raising short-term rates. The end result is a stock market peak and an economic slowdown. That's why I think there's still room for another upleg lasting into the start of the new year, but not much more after that. Admittedly, part of my fourth quarter optimism has been predicated on some softening in oil prices. If there's one factor that could undermine a strong fourth quarter rally, it's a continuing oil spike.
