ISLAND REVERSALS VIE FOR SHORT-TERM TREND -- HEAD-AND-SHOULDERS PATTERN REMAINS FOR LONG-TERM -- GOLD EXTENDS AUGUST SURGE AS SILVER HITS RESISTANCE -- GOLD:SILVER RATIO MOVING INVERSE TO STOCKS -- A TWIST ON FOSBACKS HIGH LOW LOGIC INDEX

ISLAND REVERSALS VIE FOR SHORT-TERM TREND IN SPY... Link for todays video. Even though the month is barely half over, August is full of gaps. Chart 1 shows August starting with a big gap up as the S&P 500 ETF (SPY) surged above 112 to start the month. After stalling above 112 for seven days, the ETF gapped down with an open below 111. This formed an island reversal. SPY followed through with another gap down the very next day and then consolidated around 108 for three days. Not to be out done, the ETF gapped above 109 on Wednesday to form another island reversal. These short-term reversals are keeping volatility high and swing traders busy. An island reversal is only as good as its last gap. This means Tuesdays gap above 109 marks the first short-term support zone. A move below 108 would fill this gap and negate the island reversal. Overall, SPY has been in a trading range the last three months. Range support resides around 102-104 and range resistance is around 112-113. After Tuesdays island reversal, SPY is currently in the upper half of the range. I guess you could say that the range, err cup, is half full.

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Chart 1

HEAD-AND-SHOULDERS PATTERN REMAINS FOR QQQQ... While these island reversals are short-term phenomenon and Tuesdays gaps are holding, I am concerned with potential head-and-shoulders patterns developing in the Nasdaq 100 ETF (QQQQ) and other indices. Chart 2 shows QQQQ tracing out a head-and-shoulders reversal from December 2009 until the present. Technically, the right shoulder is under construction and the pattern is not confirmed until there is a neckline support break. A break below neckline support would target further weakness to the 35-37.5 area, which marks a 50-62% retracement of the entire prior advance.

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Chart 2

Resistance at 47.5 holds the key to this bearish pattern. Last weeks long red candlestick formed the second bearish engulfing pattern in nine weeks. The mid July bearish engulfing was the first to establish resistance. QQQQ has yet to recover from last weeks decline. A move above 47.5 would negate the bearish engulfing and the head-and-shoulders pattern. I am also watching CCI resistance around the zero line. Last week this momentum indicator hit resistance around zero for the second time this summer. A break above the July-August highs is needed to turn momentum bullish again.

GOLD EXTENDS AUGUST SURGE AND SILVER HITS RESISTANCE... Gold was at it again on Wednesday with another gain. Chart 3 shows the Gold ETF (GLD) opening weak and then moving higher to close above 120 for the first time since late June. With a move from 113 to 120 since late July, GLD is up over 6% in four weeks. Not a bad move at all. The next resistance zone resides around 122-123 from the May-June highs. First support remains at 116 and major support is set at 113. Chart 4 shows the Silver ETF (SLV) with a large triangle consolidation over the last few months. The resolution of this triangle will trigger the next big signal for silver. While GDL is trading at its highs for the month, SLV remains stuck below its early August highs and shows relative weakness.

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Chart 3

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Chart 4

GOLD:SILVER RATIO MOVING INVERSE TO STOCKS... Maybe all this talk of the Hindenburg Omen is pushing money into gold as the markets head into September-October. To paraphrase Mark Twain: October is a particularly dangerous month to speculate in stocks. The others are January, February, March, April, May, June, July ...... You get the picture. Gold is probably attracting money as a safe-haven because other commodities are not following suit. In particular, silver closed down on Wednesday as bullion closed higher. Chart 5 shows the GLD:SLV ratio in black and SPY in red. Gold outperforms when the ratio rises and underperforms when the ratio falls. Gold can be considered the safe-haven metal, while silver can be considered the industrial metal. Safe-haven is winning the day when gold outperforms. Industry is winning the day when silver outperforms (gold underperforms). Turning back to the chart, notice how SPY move opposite the gold:silver ratio. These charts are pretty much mirror images, which means they are negatively correlated. Gold outperforms silver when SPY falls and underperforms silver when SPY rises. Once again, the GLD:SLV ratio moved higher in August and stocks moved lower. Safe-haven is the clear preference this month.

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Chart 5

A TWIST ON FOSBACKS HIGH LOW LOGIC INDEX... The Hindenburg Omen has garnered lots of press over the past week. Instead of rehashing the Hindenburg Omen, I would like to review Norman Fosbacks High Low Logic Index, which was created in the 1970s. In fact, Wikipedia notes that the omen is largely based on the rationale behind the High Low Logic Index. This indicator and others were covered in Fosbacks 1976 classic, Stock Market Logic. The High Low Logic Index is based on the ratio of highs to total issues and lows to total issues. Originally, Fosback used weekly numbers and smoothed the ratios with a 10-week EMA. The High Low Logic Index equals the lesser of the two ratios. The logic behind the indicator is that these ratios should vary during normal circumstances. Either the new highs ratio or the new lows ratio should be high, not both. Market conditions are abnormal when both are at relatively high levels. In fact, it is bearish to see both at relatively high levels. Since we cannot create the exact indicator on SharpCharts, I set the threshold at 2.5% for each ratio. It is unusual to see both ratios above 2.5%.

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Chart 6

With this indicator in mind, chart 6 shows the high and low ratios in the indicator windows. The first window shows the 50-day EMA of the ratio of NYSE highs to total issues ($NYHGH:$NYTOT). The second window shows the 50-day EMA of the ratio of NYSE lows to total issues ($NYLOW:$NYTOT). Going back the last 3 1/2 years, we can see that both moved above 2.5% in July 2007 and again in early November (red arrows). These moves foreshadowed the 2008 bear market. Fast forward to August 2010 and we can see that these indicators remain relatively far apart. Despite a small expansion of new lows since May, the 50-day EMA of New Lows/Total Issues has yet to move above 2.5%. The 50-day EMA of New Highs/Total Issues remains at 4.2%.

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Chart 7

Chart 8 (above) shows the same indicators for the Nasdaq. Notice that the 50-day EMAs for New Highs/Total Issues and for New Lows/Total Issues both moved above 2.5% in July and November 2007 to foreshadow the 2008 bear market. Flash forward to 2010 and we see the indicator for new highs falling below 2.5% in late June and the indicator for new lows rising above 2.5% in early July. Talk about a narrow miss. A bearish signal would have triggered had both 50-day EMAs been above 2.5% at the same time. SharpCharts users can click on these charts to see the settings and save them to their favorites.