Bearish Candle Patterns Indicate a Test of Last Week's Lows are Likely

• Short-term momentum is still oversold, so a rally is probable once the expected test is over.
• Any rally likely to be part of an overall  topping out process.
• Europe experiences primary trend sell signal.
• Japanese and Asian Ex Japan ETF’s look vulnerable from a long-term aspect.

This week we will be focusing on the equity markets since this is where most of the action appears to be developing. Recapping last week’s article, I pointed out that candlestick hammer formations being experienced by several market averages suggested a pause in the October decline that would probably be sufficient to enable three key oversold indicators to reverse to the upside, thereby clearing the way for a  short-term 3-8-week rally.  The advance did get underway, and two of those three indicators reversed. However, Wednesday’s action suggests that before higher prices can be seen a test of last week’s low is first in order.

Chart 1, for instance shows that the S&P Composite ETF, the SPY, has experienced a dark cloud candlestick pattern. That’s because Wednesday’s action caused the price to open above Tuesday’s high and close more than half way down its real body. Several other averages experienced a similar phenomenon including the NASDAQ Composite.

Chart 1

In addition the Dow ETF, the DIA, experienced a bearish engulfing pattern (Chart 2) and   the bell weather Brokers ETF( IAI) made a two bar reversal. For those unfamiliar with two bar reversals, bearish ones after an advance, are formed from two wide bars. The first opens near its low and closes near its high and the second opens near its high and closes near its low, thereby rendering all purchases made in the two day period to be losing propositions. In effect two bar reversals represent an abrupt reversal in sentiment. Such patterns are only expected to have an effect for between five and ten sessions but that should be enough to cause the market to test last week’s low, especially as so many of these formations have developed. In this respect the law of commonality says that the more a particular technical phenomenon is present  the stronger the signal. Right now equities are sporting lots of these formations. They would, of course, be invalidated in the event that Wednesday’s highs are taken out but this seems highly unlikely.

Chart 2

Chart 3

Last week I talked about some positive action coming from the small caps as a possible sign of new leadership and a justification for a rally. That theory is being questioned this week. First the Russell 2,000 ETF, the IWM experienced a bearish engulfing pattern. Second, the relative strength line, which had tentatively broken to the upside last week clearly experienced a whipsaw breakout and that’s not good news as it resets things back to the tone of the market to the days of the recent October decline, where the IWM was leading the way down.

Chart 4

Chart 5

Even so, it’s important to bear in mind that while these bearish patterns hint of some kind of a decline in the next few sessions, the three indicators I pointed to last week remain in an extremely oversold condition and  that two of them are now rising. They are shown in Charts 6, 7 and 8. Only my Bottom Fishing indicator continues to decline but it has certainly reached a very overextended level which is not far off its 2009 bear market low.  The PVO, in Chart 7, signals a selling climax when it reaches and reverses to the downside;from a high level. It did that last week, which is one of the reasons that I expect prices to experience a successful test of last week’s lows. A temporary breech of those levels would also be regarded as a successful test since that would sour sentiment even more.

If you look at the small distribution rally being signaled in the summer of 2011 at B (Chart 7) you can appreciate the kind of advance I am looking for. Greg, in his Roundup article earlier in the week, referred to a similar type advance that culminated in the 2007 peak by comparing KST action then and now. You can see that a similar set up is developing with the PVO. In the 2007 case an oversold reading was followed by a marginal new high at A. We do not know what will happen in the current situation. All I am trying to point out is that a deeply oversold condition does not necessarily mean that sustainable new highs will be seen. My assessment is that stocks are currently experiencing a topping out process i.e. forming a trading range that will precede a decline of some kind.

Chart 6

Chart 7

Chart 8

This possible scenario is justified by the fact that several long-term momentum series have started to peak out. For example, the MSCI World Stock ETF, the ACWI, has clearly violated its bull market trendline  dating back to the spring of 2009. Also, the Special K, which usually peaks and troughs with the security it is reflecting, has  violated its bull market trendline, established a series of declining peaks and troughs and crossed below its MA. None of this guarantees that global equities will fall, but given the relative reliability of  such negative Special K characteristics it seems the most likely outcome. Our bet is that following a test of last week’s low the extreme short-term oversold condition will generate a rally, possibly taking selected averages such as the S&P Composite to a marginal new all-time high. However, if that happens it will likely form part of an overall topping out process that should be used as an opportunity to sell.

Chart 9

The leader in the current market is Europe, as represented in Chart 10 by the Europe Top 350 IEV. The problem in this case is that the leadership is on the downside with both the price and the Special K having completed major tops. It’s fairly evident without resorting to indicators that this ETF is currently very overextended on the downside, so some kind of rally appears likely.

Chart 10

The Asia Ex Japan ETF, the EPP has also experienced a major Special K trendline break as well as a negative MA crossover. You can also see that the quality of the bull market has been deteriorating as the price and Special K have been diverging negatively for a while. Earlier in the month the price violated the trendline but has now moved back above it, so we cannot, at this time, say that the price has confirmed the negative momentum action. That can only happen with a break below the recent low at $45. However, given the weak long-term momentum such a possibility cannot be ruled out.

Chart 11

Finally on the long-term equity front, we see that the Special K for the Nikkei ($NIKK) has completed a major top and violated its MA. This action has not yet been confirmed by the Index itself, which would complete a top of its own with a decisive break below the 14,300 level or so. However, this seems likely as the Special K usually leads the way. Consequently its attainment of a 16-month low this week is not a favorable sign for Japanese equities.

Chart 12

Good luck and good charting!

Martin Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group or its affiliates.