WATCHING MONDAYS GAPS (QQQQ,RSP), SMALL-CAPS AND FINANCE SHOW RELATIVE WEAKNESS ($RUT,XLF), XLB STALLS NEAR PRIOR HIGHS, USING THE STOCHASTIC OSCILLATOR IN A TRADING RANGE (XLI), BONDS FIRM AT SUPPORT (TLT,IEF)

WATCHING THE GAPS... Link for todays video. The major index ETFs gapped higher and closed strong on Monday. Even though trading since the gap has been subdued, the gaps are holding and remain bullish until proven otherwise. Chart 1 shows the Nasdaq 100 ETF (QQQQ) gapping up and closing above 43. The orange highlight marks the gap zone. The bulls are in good shape as long as this zone holds. A move below this zone would fill the gap and totally erase Mondays gains. Such a move would show underlying weakness that could lead to a bigger support test around 41. For now, the gap is holding and this is a show of strength. Even though QQQQ stalled the last three days, it has yet to actually give up its gains. Chart 2 shows the Rydex S&P Equal Weight ETF (RSP) with a similar gap on Monday.

Chart 1

Chart 2

Educational Note: There are three types of gaps: breakaway, continuation and exhaustion. Breakaway gaps signal the start of a move. Continuation gaps occur during a move. Exhaustion gaps occur at the end of a move. Mondays gap is currently classified as a (bullish) continuation gap because stocks have been moving higher since mid July. A close below the gap zone would fill this gap and it could then be considered an exhaustion gap, which would be bearish.

WARNINGS PERSIST ... We have yet to see medium-term trend reversals or significant weakness in most major indices, but a few warnings signs are still lurking. In addition to low volume noted in Wednesdays commentary, I am seeing relative weakness in the small-caps and the finance sector. The Dow broke above its October highs, while the S&P 500 and the Nasdaq are near their October highs. These three are holding their uptrends and have yet to break down. However, the Russell 2000 ($RUT) and the Financials SPDR (XLF) remain well below their October highs and show relative weakness. Chart 3 shows the Russell 2000 breaking support and forging a lower low in late October. With a rebound back above 590, the index retraced 50-62% of the prior decline. Was this support break a bear trap or is the move above 590 destined to fail? Technically, the Russell 2000 looks bearish with the lower low and MACD(5,35,5) in negative territory**. Watch for a move below 580 to reverse the two week uptrend and fill Mondays gap. Also watch for a bearish signal line cross in MACD (5,35,5) to confirm. As the weakest of the major indices, I would expect the Russell 2000 to lead the way lower if stocks experience a broad decline.

Chart 3

Chart 4 shows the Financials SPDR trading below its October high. The ETF bounced with the rest of the market, but hit some resistance around 15 and fell short of its October high. Even though XLF is lagging the S&P 500, it is still trending higher the last two weeks. The ETF gapped up with the rest of the market on Monday and this gap is holding. Look for a move below this gap zone to signal trouble ahead. Right now the gap is holding and remains bullish until proven otherwise (filled). The bottom indicator shows MACD (5,35,5) peaking in early August and working its way lower the last few months. MACD is short-term bullish after moving back above its signal line last week. Look for a move back below the signal line to show weakening momentum in XLF.

Chart 4

DOJI SIGNAL INDECISION... Doji are candlesticks that signal indecision. Doji look like plus signs (+) because there is little change from open to close. In addition, the upper shadow (high) is about the same size as the lower shadow (low). Doji can sometimes foreshadow a bearish reversal after an advance, but they are neutral until there is an actual reversal. The key is to wait for some sort of downside dynamic or reversal confirmation. Candlesticks patterns are short-term, which means they are valid for 1-2 weeks. While a bearish candlestick reversal would affect the short-term uptrend, it would not be enough to affect the medium-term uptrend.

Chart 5 shows the Materials SPDR (XLB) for a live example. The ETF established resistance around 33 with reaction highs in September and October. After a 10% advance in early November, XLB formed a doji on Wednesday and stalled on Thursday. This is sudden indecision after an advance, but it is not the same as weakness. Some sort of downward dynamic is needed to actually reverse the two week uptrend. This could come with a break below the blue trendline or a bearish crossover in MACD (5,35,5). Notice that MACD (5,35,5) formed bearish divergences in Aug-Sep and Sep-Oct, but these did not result in a significant decline. Instead, the ETF has traded on either side of 30.5 since August (blue dotted line). MACDs decline from high levels reflects 3+ months of sideways price action.

Chart 5

XLI STALLS NEAR RESISTANCE... Chart 6 shows the Industrials SPDR (XLI) in a situation similar to XLB. After a 10% surge in early November, XLI is stalling with doji on Tuesday and Wednesday. In addition, the ETF is near resistance from the September-October highs. Throw in support from the October-November lows and it looks like we have a trading range on our hands. Trading ranges are best suited for momentum oscillators and I am using the Stochastic Oscillator in this example. Since the trading range started, XLI turned down as the Stochastic Oscillator moved below its signal line AND below 80. Conversely, the move above the signal line AND above 20 signaled a short-term advance. With the Stochastic Oscillator above 80 and below its signal line, it looks like the next signal will be bearish. Look for a move below 80 for confirmation. Again, this is a short-term signal that would warrant close attention.

Chart 6

BONDS FIRM AT SUPPORT... There are plenty of reasons to be bearish on normal bonds. First, we have inflationary pressures from easy money and relative strength in inflation-protected bonds. Second, there are supply concerns as the Treasury finances the growing deficit. Third, the Feds balance sheet is loaded with bonds it must sell one day. These concerns certainly merit attention, but we cannot ignore what is happening on the chart. Chart 7 shows the 20+ Year Treasury ETF (TLT) firming at support around 92.5-94. The ETF remains within a falling wedge pattern and has yet to surge off support. A move above this weeks high would break wedge resistance and affirm support. As a bullish breakout, it would also signal a continuation of the August-September advance.

Chart 7

The bottom indicator window shows TLT with the DB Commodity Index Tracking ETF (DBC). There is a negative correlation here: bonds rise as commodities fall and bonds fall as commodities rise. The rise in commodities since late September weighed on bonds, but DBC has flattened out the last few weeks. Obviously, an upside breakout in DBC would be bearish for bonds. However, a downside break could lift bonds.

Chart 8 shows the 7-10 Year Treasury ETF (IEF) holding support in late October and bouncing the last few weeks. First, notice that IEF broke resistance with a big surge in late September. Even though this breakout did not hold, IEF did forge a higher high. Second, the decline back to 90 retraced around 50% of the prior advance and IEF held its September lows. Is there another leg down or will support at 90 hold? Right now I give the edge to the bulls because support is holding and the wedge is rising. A break below last weeks lows would break wedge support and signal a continuation lower. I also suspect that the bond market will not move higher unless stocks and commodities move lower.

Chart 8