FINANCE AND TECHNOLOGY LEAD MARKET LOWER -- VOLATILITY INDICES BREAKOUT AS FEAR INCREASES -- COAL ETF BOUNCES OFF SUPPORT -- COMPARING RSI AND THE STOCHASTIC OSCILLATOR -- RATE-OF-CHANGE INDICATOR BECOMES OVERSOLD

FINANCE AND TECHNOLOGY LEAD MARKET LOWER... Link for todays video. Stocks came under selling pressure again on Wednesday. All sectors were down with finance and technology leading the way. Chart 1 shows the Finance SPDR (XLF) breaking the support zone in the 16.25 area with a sharp decline the last five trading days. I dare say that the bigger trend remains up and this appears to be a correction within this uptrend. After a surge from 14.25 to 17.25 (21%), the ETF is entitled to a pullback or correction. Broken resistance, the December dip and the 62% retracement mark a possible support zone in the 15.50 area. The indicator window shows the Price Relative moving lower since January, which means XLF is underperforming the broader market.

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Chart 1

Chart 2 shows the Technology ETF (XLK) falling off a cliff the last two weeks. The ETF is down over 8% from the February high. As with XLF above, there is an argument to be made that this is a correction within a bigger uptrend. After all, the ETF broke the April high with a 30+ percent surgee from late August to late February. There was a small pullback in November, but no real correction. A 50% retracement of the August-February advance would extend to the 23.77 area. Broken resistance and the November low confirm support here. The indicator window shows the Commodity Channel Index (CCI) moving below -200 for the first time since the May 6th flash-crash. There was a sharp bounce after this oversold reading, but the ETF continued lower into late May and June. The current decline could be compared to this flash-crash because of its depth and speed.

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Chart 2

VOLATILITY INDICES BREAKOUT AS FEAR INCREASES... The CBOE Volatility Index ($VIX) and the Nasdaq 100 Volatility Index ($VXN) both broke above 25 and exceeded their August highs. Even though neither has yet to reach the May 2010 highs, the current surge is the sharpest since April-May, when both surged from around 16 to the mid 40s. This surge was exasperated by the May 6th flash crash. Chart 3 shows the CBOE Volatility Index ($VIX) surging above 25 in January 2010, May 2010 and now March 2011. Surges above 25 were qualified by requiring the indicator to dip below 20 beforehand. This criterion simply insures a relatively low VIX before the breakout. The first two breakouts at 25 coincided with a downturn in the S&P 500. The January downturn was relatively short, but the May downturn lasted until the end of June. The current surge marks the third such signal in 15 months. Stocks did not find support until the VIX formed lower highs in February 2010 and June 2010. At this point, it could take a couple weeks for tensions to settle down and lower highs in the VIX to take shape. A surge in the VIX indicates that the implied volatility of S&P 500 put options is rising. This means demand for put options, which rise in value as the S&P 500 declines, is increasing. Chart 4 shows the Nasdaq 100 Volatility Index ($VXN) with similar characteristics.

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Chart 3

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Chart 4

COAL ETF BOUNCES OFF SUPPORT... With the recent nuclear-related problems in Japan, investment attention has turned to some of the alternatives. Chart 5 shows the Coal Vectors ETF (KOL) holding up rather well over the last few days. The ETF surged from the low 30s to 50 and then consolidated with a flat consolidation. With the prior move up, this is viewed as a bullish continuation pattern and a move above the March high would be bullish. Support is well-defined with at least four reaction lows since late January. A break below these lows would signal an increase in selling pressure that would target a move towards the next support zone around 40.

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Chart 5

COMPARING RSI AND THE STOCHASTIC OSCILLATOR ... A few, but not all, momentum oscillators became oversold with the sharp decline over the last few weeks. While all momentum oscillators measure momentum, some are more sensitive than others, even when using similar timeframes. In other words, some become oversold rather quickly and some more sustained selling pressure to generate oversold signals. The Stochastic Oscillator and RSI make a good case in point. The 14-day Slow Stochastic Oscillator is a rather sensitive oscillator that moves from overbought to oversold quite frequently. This frequency can be reduced by lengthening the look-back period. For example, a 28-day Slow Stochastic Oscillator will become overbought or oversold less frequently. Because the 14-day Slow Stochastic Oscillator hits overbought/oversold extremes quite frequently, these signals will be more prone to whipsaw and failure.

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Chart 6

RSI is at the other end of the spectrum. 14-day RSI has its share of overbought/oversold readings, but far fewer than the 14-day Stochastic Oscillator. In fact, chart 6 shows RSI without any oversold readings (<30) from April-2009 to the present. There were, however, numerous overbought readings. This is classic action for RSI during an uptrend. The indicator becomes frequently overbought and seldom, if ever, oversold. The converse is true during a downtrend. RSI becomes frequently oversold and seldom, if ever, overbought. Using these indicators to identify oversold conditions within an uptrend is difficult because the Stochastic Oscillator hits extremes too often and RSI hits its extremes too seldom.

RATE-OF-CHANGE INDICATOR BECOMES OVERSOLD... The Rate-of-Change indicator is perhaps the purest momentum oscillator around. It simply measures the percentage Rate-of-Change from one period to the other. Like RSI, it can be used to identify overbought and oversold conditions. In contrast to RSI and Stochastics, which fluctuate between zero and one hundred, the Rate-of-Change Indicator does not have upper and lower limits. In theory, it could go to infinity and beyond, just like Buzz Lightyear. In reality, it does not and can be used to identify overbought/oversold extremes. Chart 7 shows the 12-day Rate-of-Change fluctuating between 11.5% and -8.75% since May 2009. A simple visual assessment indicates that -5% is an important level because the indicator does not remain below this level for long. Therefore, moves below -5% suggest an oversold condition that could give way to a bounce in the future. The blue arrows show dips below -5%.

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Chart 7

An oversold reading is not reason enough to turn bullish. Sometimes an oversold reading will pick the bottom and sometimes oversold conditions persist as the downtrend extends, such as May-June. Oversold conditions serve as an alert more than an actual signal. Chartists should be on alert for a bullish reversal, a pattern breakout, a moving average crossover or some other complimentary signal. Such a signal indicates that the correction has not only ended, but also that some sort of upturn has started. The lower indicator window shows MACD(5,35). This indicator turns positive when the 5-day EMA moves above the 35-day EMA. Such a move would signal that some sort of upturn was commencing. There were some good reversal signals and some bad reversal signals (late June 2009 and early July 2010). As the chart now stands, the Rate-of-Change indicator just dipped below 5% to put traders on alert to watch for a possible signal from a complementary indicator.