FINANCIAL STOCKS APPROACH TEST OF MAJOR SUPPORT -- SMALL CAPS CONTINUE TO WEAKEN ALONG WITH MARKET BREADTH -- THE 13-AND 34-DAY EMA COMBINATION SHOWS S&P TREND STILL UP BUT STARTING TO WEAKEN

FINANCIAL SPDR NEARS TEST OF SPRING LOW ... One of our readers asked me recently if the daily chart of the Financials SPDR looked like a bullish "triangle" or a bearish "double top". This week's downside action has pretty much ruled out the "triangle". In a triangle formation, the biggest downleg shouldn't retrace more than 62% of the height of the pattern. Chart 1 shows the XLF falling well below that level (see horizontal lines). That leaves two other possibilities. That the sideways action since February is just a sideways "trading range" within the major uptrend, or a "double top". The answer to that will depend on whether or not it stays over its March intra-day low at 34.53. If it doesn't, a bearish "double top" will have been completed in the financial sector. Unfortunately, some of our technical indicators lead toward the more bearish view. For one thing, it's trading below its 200-day average by the widest margin in two years.. Another is the huge volume during the recent selloff. That's not indicative of a trading range. The weekly chart also looks ominous.

Chart 1

FINANCIALS ALSO TEST MAJOR SUPPORT LINE ... The weekly bars in Chart 2 show how important the test of this year's low really is. Not only is it important chart support; it also represents a test of major support line connecting the 2003, 2005, and 2006 reaction lows. A breaking of chart support, together with a break of the four-year support line, would be very bearish indeed for financial stocks. The trend of the weekly MACD lines (top of chart) isnt very encouraging. The MACD lines peaked at the same level as in 2004, have turned negative, and are already trading at a two-year low. [The monthly MACD lines are also in danger of turning down]. I suggested a few weeks ago that a minor downturn in financial stocks might not worry the market too much. A break of major support at this year's lows, however, would most likely be enough to cause more serious profit-taking in the rest of the stock market.

Chart 2

SMALL CAPS CONTINUE TO WEAKEN ... On Friday, I zeroed in on two market groups that were contributing to the recent deterioration in market breadth. One was financials (together with housing and REITS). The other was small (and midcap) stocks. I pointed out that the Russell 2000 Small Cap Index had failed a test of its June high (as did the S&P 600 Small Cap and the S&P 500 Mid Cap Indexes). Today's action shows the Russell 2000 iShares (IWN) falling 1.5% to lead the rest of the market lower and undercutting its 50-day average. It appears headed toward its 200-day line. Downside volume has also been heavy over the last week (red volume bars). The small cap relative strength ratio (bottom of chart) has fallen to the lowest level in nearly a year. Although large caps are holding up a little better, they're starting to give some ground as well.

Chart 3

WATCHING MA LINES FOR SELL SIGNALS ... I received several messages today asking how to tell when a sell signal is given. At the same time, I was asked to update the 13-34 day EMA trading system. I can fulfull both requests by doing that. The 13-34 EMA system compares two exponential moving averages (EMAs) as shown in Chart 4. The blue line is the 13-day EMA and the red line is the 34 day EMA. [EMAs are more sensitive than simple averages. 13 and 34 are also Fibonacci numbers which are widely used by professional traders]. There are two aspects to the system. One is simply the fact that an uptrend exists when the blue line is higher than the red line. Buy and sell signals are given when the lines cross. The last buy signal was given in late March (up arrow). At the moment, the two lines are still in an uptrend. There's a second aspect to the system having to do with the spread between the two lines. The black line at the top of Chart 4 plots the difference between the lines. Crossings above or below the zero line coincide with buy and sell signals (see arrows). The black line is used to spot bullish and bearish "divergences". Chart 4 shows that, although the trend is up (above the zero line), the spread hasn't kept pace with the recent price advance, and is starting to narrow. That 's usually the warning of an impending market correction.

Chart 4

Chart 5

HOW TO SPOT EMA DIVERGENCES ... Chart 5 plots the spread between the 13-day and 34-day EMAs overlayed on the S&P 500 chart (red line) over the last three years. [You can plot the spread by applying 13,34,1 to the daily MACD system]. The red down arrows show negative divergences between the two lines. [A negative divergence exists when the black line doesn't confirm a move into new highs by the S&P 500]. Previous ones occurred in early 2005, the spring of 2006, and the first quarter of 2007. All were followed by downside corrections of approximately 5%. The last red arrow shows that another "negative divergence" exists at the moment. That's an early warning of a possible correction in the making. An actual short-term sell signal won't occur however, until the 13-day EMA crosses below the 34-day EMA, and the spread between the two falls below the zero line. The daily signals only tell when the short-term trend is changing direction. You can apply the same values to the weekly (and monthly) charts for longer-term signals. Chart 6 applies the 13- and 34-week EMAs to the S&P 500. That combination has been bullish since the spring of 2003, and still is. Of minor concern, however is the fact that the weekly spread (top of chart) is stalling a bit at its early 2004 peak (red circle). That may be an early sign that the long-term uptrend is starting to lose some upward momentum.

Chart 6