OVERBOUGHT READINGS AND THE 2006-2007 ADVANCE -- CCI FOR S&P 500 SURGES TO HIGHEST LEVEL SINCE APRIL -- HEAD-AND-SHOULDERS TARGET FOR S&P 500 -- NIKKEI 225 GAPS UP TO FORM RIGHT SHOULDER -- POSITIVE CORRELATION BETWEEN NIKKEI AND 10-YEAR T-YIELD
OVERBOUGHT READINGS AND THE 2006-2007 ADVANCE ... Link for todays video. The Commodity Channel Index (CCI) is a popular momentum oscillator that fluctuates above/below the zero line. Unlike RSI and the Stochastic Oscillator, CCI is not bound on the upside of the downside. Typically, a reading above +100 is considered overbought and a reading below -100 is considered oversold. However, it is not uncommon to see the indicator surge above +200 or plunge below -200. CCI has also exceeded +300 and -300 on a few occasions.
It is important to remember that overbought readings occur because of exceptional strength. Conversely, oversold readings occur because of exceptional weakness. The more extreme these overbought/oversold readings, the more exceptional the strength/weakness. Some overbought readings will coincide with important tops and some oversold readings will correspond with significant lows, but these are often the exception, rather than the norm.
During a strong uptrend, extreme overbought readings may increase the chances of a pullback, but do not guarantee a pullback. Chart 1 shows the S&P 500 from July 2006 until January 2008. CCI hit the +200 area four times from July 2006 to July 2007 (red arrows). Even with a series of overbought readings, the pullbacks were short and index rallied over 25% during this timeframe. A top did not form until CCI surged above +250 in September 2007. This surge did not mark the exact high as the index advanced another 2-3 weeks after this extreme overbought reading. A major trend reversal did not occur until the S&P 500 broke double top support in January 2008. Also note that this top took a good six months to form.
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Chart 1
CCI FOR S&P 500 SURGES TO HIGHEST LEVEL SINCE APRIL... Chart 2 shows the S&P 500 with the Commodity Channel Index (CCI) over the last two years. CCI moved above +200 in May and June 2009. These extreme overbought readings foreshadowed the May and June pullbacks. Notice that these were just short pullbacks, not major peaks. After these two +200 readings, CCI did not cross back above +200 until November 2010. Yesterdays CCI of 268.78 was the highest since September 2007. The 1962 theme from The Twilight Zone should kick in about now. Comparing the current chart to 2007, it is possible that the S&P 500 is entering a period similar to April 2007, which is when CCI exceeded +200 and the index broke its February high. This advance continued three months before a peak in July 2007. No two tops are exactly the same, but tops usually evolve with some sort of large consolidation, such as a double top or head-and-shoulders. These take time to form and there is no evidence of a major top formation yet.
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Chart 2
HEAD-AND-SHOULDERS TARGET FOR S&P 500 ... Chart 3 shows the S&P 500 forming an inverse head-and-shoulders reversal pattern from late May until early September. The shoulder lows were around 1040, the head low was near 1010 and neckline resistance was at 1130. The index broke above neckline resistance in mid September and never looked back. Based on classic technical analysis, the distance from head to neckline would be added to the neckline breakout for an upside target. This targets a move to around 1250, which is another 30 points higher. The index may be overbought and still ripe for a pullback, but this inverse head-and-shoulders breakout and the current uptrend dominate the picture right now.
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Chart 3
While on the subject of the inverse head-and-shoulders, lets take a look at volume, which forms an important part of this pattern. Volume trends were uninspiring from May until August. The index declined on heavy volume in May-June. The July low and first surge were also marked with below average volume. It was not until early September that upside volume started picking up. The green volume bars are up days, the red bars are down days and the blue line is the 63-day SMA (one quarter). The early September volume trend stayed bullish as the index continued its advance in October with good volume. The second indicator window shows On Balance Volume (OBV). This indicator formed a higher low and broke above its July high in mid September. After this small show of strength, OBV broke above its prior highs with the October surge.
NIKKEI 225 GAPS UP TO FORM RIGHT SHOULDER... Speaking of inverse head-and-shoulders patterns, the Nikkei 225 ($NIKK) could be tracing out this bullish reversal pattern right now. The overall trend remains down, but the index flattened out from July to November. Chart 4 shows the left shoulder forming in July, the head in late August and the right shoulder currently under construction. With a gap and surge above 9600 over the last two days, the index put in a reaction low to form the right shoulder. Though not shown on the chart, the index closed at 9626 on Friday. A break above neckline resistance and the October high would complete the pattern. Upon completion, the upside target would be to around 10650.
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Chart 4
POSITIVE CORRELATION BETWEEN NIKKEI AND 10-YEAR TREASURY YIELD... Believe it or not, we should watch the 10-year Treasury Yield ($TNX) for clues on the Nikkei 225. Yes, you read right! The positive correlation between the Nikkei and the 10-year Treasury Yield was pointed out by John Murphy in his classic book, Intermarket Analysis. Murphy attributed this correlation to the inflationary and deflationary pressures reflected in the 10-year Treasury Yield. Japan has been in a deflationary spiral for years. The ups and downs of the 10-year Treasury Yield either amplified this spiral or brought relief. US yields rise when global inflationary pressures are present, which is positive for the Nikkei 225. US yields fall when global deflationary pressures are present, which is negative for the Nikkei. Chart 5 shows these two together over the last 21 months. It is quite remarkable how closely their movements match. Even though the 10-year Treasury Yield plunged to new lows in early October, the Nikkei remains above its late August low and shows some relative strength. The 10-year Treasury Yield has yet to turn the corner. A move above the late October high is needed to reverse this downtrend.
