Markets

Does This Relief Rally Have Legs?

SAN DIEGO (ETFguide.com) Did you know that it's possible to photograph a mirage? A mirage is a real optical phenomenon that produces a displaced image of distant objects or the sky (which in the desert often looks like water). A mirage looks real and can even be captured on camera but is nothing more than an optical illusion.

Looking at the current stock rally I ask myself is it for real or is it a mirage?

You could look at the recent events through bullish or bearish glasses and find enough data to support either view. But a biased market forecast is of as much (or little) value as a biased judgment. So let's look at different data points and draw an objective conclusion.

Up Trend Broken

The chart below shows the Dow Jones Industrials (DJI: ^DJI) since the March 2009 bottom. The DJIA weekly candle low touched the yellow trend line on different occasions before breaking through it on August 2.

The S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) adhered to a similar but not as pronounced trend line. But the S&P also had a key experience on August 2. The August 2 ETF Profit Strategy Newsletter update observed regarding a head and shoulders top that the: 'S&P is about to break below the neckline around 1,249. A break below this neckline would unlock a measured target of S&P 1,140.'

The fact that both the DJIA and S&P 500 broke through necklines that have held for over two years is less than encouraging.

In addition, the S&P's May 2 high at 1,370 occurred right within the sweet spot of a major market top. The ETF Profit Strategy Newsletter published the chart below on various occasions throughout March, April and May and preached that S&P 1,369 - 1,382 is the ideal target range for a major market top (chart below was featured in the April 5 ETF Profit Strategy update).

Death Cross

The death cross is one of the most talked about technical events, that's why I don't put too much stock in it. However, there are two interesting facts about previous death crosses.

The 2000 and 2007 death cross occurred about three days before the S&P embarked on its next leg down. The 2010 death cross was actually a buy signal. However, it occurred after the S&P and DJIA bounced off the yellow trend line (this time the trend line was broken).

Seasonality

August, September, and October is the most bearish stretch of the year. September and October sport negative performance even in the pre-election year.

Sentiment

From S&P 1,370 on May 2 to S&P 1,258 on June 16, the S&P shed 112 points and sentiment measured by Investors Intelligence (II) and the American Association for Individual Investors (AAII) turned deeply bearish. The June 16 ETF Profit Strategy update took that as a queue to buy (long positions were closed at S&P 1,340).

From S&P 1,353 on July 7 to S&P 1,102 on August 9 the S&P lost 251 points, yet the II sentiment poll registered the second most bullish reading since the first week of May. AAII and II polls are often considered the 'dumb money.' If the 'dumb money' views last Wednesday's low as a buying opportunity, the 'smart money' should be suspicious.

Breadth

We all know that the selling over the last few weeks was heavy. Shortly before the August 9 low was reached, there were 69 stocks down on the NYSE for every stock that was up. That's extreme and could be considered a capitulation sell off. The buying since the low has been heavy as well. In fact, there were three up days where more than 90% of the trading volume came from the buy side. That's generally a positive for stocks going forward.

VIX Pattern

If you have the charting capabilities, take a moment and plot the VIX (Chicago Options: ^VIX) against the S&P for the month of September - November 2008 and April - July 2010. If you don't have the time you may simply look at the chart below.

What we've seen in 2008 and 2010 is that a VIX peak did not coincide with the S&P bottom. The S&P bottom actually occurred against a lower VIX reading. If this pattern continues, we will see lower lows.

The August 14 ETF Profit Strategy Newsletter update includes a detailed analysis of the VIX pattern, along with the time frame and target level for an expected turn.

The Script

Via more or less accidental chart surfing I found a striking resemblance between the 2007 market top and the May 2011 top. This moved me to state in the July 17 Profit Strategy update that:

'There is a similar trend line and a triple top above the trend line. A break below that trend line could be a precursor of bad things. Next week the trend line will be at about 1,262.'

The S&P sliced through that trend line on August 4 and fell an additional 12% within the next four days (this ascending trend line is now a big target and resistance).

The August 7 Profit Strategy update revisited that script and concluded this: 'We now have a rough script; let's see how much lip the actors will add during the live performance (I.e. S&P downgrade).

The two main things I have taken away from the 2007 script are:

1) There will be a new low.

2) There will be a powerful counter trend rally to around 1,xxx (reserved for subscribers).'

The Verdict

We got the new low and we got a rather powerful rally. Now the question is, how long will the low last and how high will stocks rally?

The script suggests one way or another, there will be another low. The VIX pattern suggests there should be another price low. Seasonality suggests that there's some headwind on the way up. Sentiment readings suggest we should be suspicious of any rally. Breadth, since the August low, suggests the rally may have legs.

The death cross is somewhat inconclusive with perhaps a slight bias towards the downside, and the broken trend line suggests that the trend may have changed from up to down. This would mean that any rally is now considered a counter trend rally and an opportunity to sell stocks or short stocks.

Here is how I would approach the current situation: Based on the facts, I believe we'll see another low. However, the market doesn't care much about what I think so let's allow the market to guide us.

On Friday the S&P closed above 1,173. This has been pretty significant support/resistance. With the S&P above this level, it is now support. As long as the S&P stays above 1,173 the short-term trend is up.

If the S&P approaches our upside target it's time to become cautious again and put any long positions on a very short leash or even short the S&P, or your (least) favorite sector.

It may also pay to watch if the Financial Select Sector SPDR (NYSEArca: XLF) and KBW Bank ETF (NYSEArca: KBE) confirm the S&P's moves. Thus far KBE is lagging.

The ETF Profit Strategy Newsletter takes an out-of-the-box approach to financial analysis and uses various tools to identify important support/resistance and target levels. The most recent update includes the target for this rally and an intermediate bottom.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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