TECHS LEAD OVERSOLD BOUNCE -- A HEAD-AND-SHOULDERS FOR DIA -- DOUBLE TOPS FOR SPY AND IWM -- DOW THEORY AND TREND INDENTIFICATION -- SMALL CAPS REMAIN RELATIVELY WEAK
OVERSOLD TECHS FIND SOME FOOTING... Today's Market Message was written by Arthur Hill. John Murphy will return tomorrow. - Editor
After becoming oversold, the stock market rebounded on Wednesday with techs leading the way. As Chart 1 shows, the Nasdaq 100 ETF (QQQQ) gained over 2% and formed a harami over the last two days. A harami is a bullish candlestick reversal pattern that requires confirmation with further upside. It forms when the body of the second candlestick (Wednesday) is within the body of the first candlestick (Tuesday). The open and close form the body. At the very least, this harami signals support and QQQQ may be in for an oversold bounce or a consolidation. Also notice that the ETF became oversold as RSI dipped below 30 the last few days. Today's gain pushed RSI back above 30 to alleviate oversold conditions. On the price chart, broken support and last week's gap combine to mark a resistance zone around 49-50 and QQQQ could bounce to this area.
Chart 1
BIG REVERSAL PATTERNS STILL IN PLAY... Despite today's bounce, many of the major index ETFs remain with large bearish reversal patterns working. More importantly, some of these patterns were confirmed with key support breaks over the last two weeks. The next three charts are based on weekly prices so the last candlestick is still a work in progress. There are two days left in trading this week.
The Dow Industrials ETF (DIA) has a large head-and-shoulders reversal pattern working, while the S&P 500 ETF (SPY) and Russell 2000 ETF (IWM) both formed large double tops. Let's look at each chart individually. Chart 2 shows the Dow Industrials ETF (DIA) breaking the neckline support zone. The distance from the top of the head to neckline support is subtracted from the neckline break for a downside target. For DIA, the downside target is around 113. Also notice that DIA cleanly broke the 40-week moving average, which is equivalent to the 200-day moving average.
Chart 2
DOUBLE TOPS FOR SPY AND IWM... Charts 3 and 4 show the S&P 500 ETF and Russell 2000 ETF with double tops. SPY peaked around 155 in July and again in October. The ETF established support at 140 in August and November. The break below key support in January confirms the double top. In addition, SPY convincingly broke the 40-week moving average. The length of the double top is subtracted from support break for a downside target. In the case of SPY, the downside target is around 125. IWM formed a double top with resistance around 85 and support around 73-74. The ETF broke support in late December and continued lower in early January. The next target is support around 66, which is marked by the June-July 2006 lows.
Chart 3
Chart 4
DOW THEORY AND THE TREND... Before moving on, I would like to caution readers on targets. These targets are rough guidelines and should be taken with a grain of salt. The important thing is the trend changes that are currently underway. As Chart 5 shows, lower highs have been followed by lower lows over the last few months. This is the basic definition of a downtrend. There will be oversold bounces and counter-trend rallies along the way. Advances will be deemed counter-trend moves as long as the December highs hold (red arrows). According to Dow Theory, neither the length nor the duration of the trend can be determined. The best we can do is identify the trend and act accordingly.
Chart 5
SMALL CAPS STILL SHOWING RELATIVE WEAKNESS... Relative weakness in small caps has been a theme since mid summer and this theme remains dominant in the stock market. Chart 6 shows the IWM:OEF Ratio, which is also known as the price relative. The S&P 100 ETF represents large caps and the Russell 2000 ETF represents small caps. The IWM:OEF ratio rises when IWM outperforms and falls when IWM underperforms. The ratio peaked in February 2007 and broke support with a sharp decline in July. This was a clear signal that small caps were leading the way lower. The ratio moved to a new low in January as small caps led the stock market lower. When it comes to the economy, small companies are more vulnerable than large companies. They are often less diversified and more dependent on the overall state of the economy. Relative weakness in small caps is a vote for weakness in the economy. Earlier today, an economist at Goldman Sachs predicted a recession this year. This prediction certainly jibes with eight months of relative weakness in small caps. In fact, it looks like small caps beat Goldman to the punch!
Chart 6
The individual charts for the Russell 2000 ETF and S&P 100 ETF are shown at the bottom of Chart 6. These charts confirm relative weakness in small caps. OEF forged a higher high in October, but IWM formed a lower high. The inability to break the summer high showed relative weakness. During the October-November decline, IWM broke its August low, but OEF held its August low. Again, the lower low showed relative weakness in IWM and small caps.
