What a difference a week makes. Overnight we saw the Dow Jones fall over 200 points for the second time within a week. I wrote last Wednesday and focused my attention on the level of 1422 in the S+P 500.
The horizontal line in the chart is the level of 1422, which was the high made in April this year. My view has been that a weekly close below that level will spell trouble for the stock market ahead.
Last night the S+P 500 closed at 1413, having fallen 3% in the last three sessions. If the S+P 500 remains below 1422 until Friday night then my weekly sell signal will be triggered.
The reason I’ve focused on the April high of 1422 is because I believe a false break of that high is the first sign that the momentum is shifting back to the downside.
When a stock market trades above a previous high it will often look like a breakout to novice stock traders. This inspires buying and forces people who were short selling the stock market to cover their positions, which creates even more buying. The stock market will spike higher and for a few weeks can look fantastic.
But then the music stops and suddenly the stock market plunges lower and closes below the previous high.
If a lot of the previous buying was short sellers covering their positions then when they stop buying there is no follow through.
Also, if new entrants were trying to buy the breakout you can rest assured they will be getting nervous when the stock market fails to hold above the key level. A lot of them will dump their new positions in this scenario.
So what was strong buying only a few weeks prior can quickly turn into strong selling pressure. Professional stock traders will know this and they can sell the stock market short with a very tight stop loss because they know that if the stock market trades above the recently made highs they will be proven wrong.
The risk/reward in this scenario is very good for the professional stock trader. A false break of a major high can often be the beginning of a large move to the downside. Major turning points in the stock market will often begin with this type of price action.
Another reason why I’ve warned you to tread carefully lately is that my trending signals have been shifting to the downside. I use the 10 day exponential moving average and the 35 day simple moving average to give me a clue about the intermediate trend (I see the stock market as having three intertwining trends — the short, intermediate and long).
If you have another look at the above chart you’ll see I’ve circled each time the intermediate trend has turned down in the S+P 500 over the past few years.
This signal has been very timely in warning that some selling was imminent. In August 2011 the signal came just prior to a 200 point sell-off in the S+P 500. In April this year it turned down at the beginning of a two month sell-off.
It’s quite clear from the past data that you shouldn’t ignore this signal.
So in the last few days the S+P 500 has confirmed a false break of a major high and has shifted into an intermediate downtrend.
The stock market as a whole remains incredibly complacent because there aren’t many people out there who analyse markets in this way. It won’t be until the stock market is much lower than here that we will see investors getting nervous.
Remember that US Federal Reserve chairman, Ben Bernanke announced QE3 with the stock market higher than it is now. I think that’s a very ominous sign. If eternal money printing can’t send the stock market to ever greater heights at a time when companies are reporting a weak set of results and guiding their revenue projections down, I would be very wary of buying equities with ears pinned back as some are doing.
The US fiscal cliff remains a real concern going forward, and though we should expect to see some sort of compromise and can kicking at the eleventh hour as usual, there may be a lot of nervous days trading prior to that outcome.
The ‘Bernanke put’ may still be in play but let’s face it; Bernanke showed his hand already and can’t be seen to be jumping to the stock markets rescue at the first signs of trouble. If he does step in again I think it will be with the stock market a lot lower than it is now. As always with the ‘Bernanke put’ you have to ask yourself what the strike price is.
The ASX 200 is currently performing much better than offshore markets after a long period of underperformance. This theme may continue for the foreseeable future while investors continue to pile into the banks in search of yield. But if the US markets are in the process of tracing out a multi-month high you can be sure that we will end up following them lower in time, even if we don’t fall as much as they do.
You can see from the above chart that the ASX 200 is still in intermediate uptrend (blue line above the red line), but that the RSI (Relative Strength Index) is looking quite overbought. So the jury is still out on the ASX 200 but my conviction that more downside is imminent will go through the roof if the ASX 200 closes below the recent high of 4448 (horizontal blue line in chart above).
That sell signal will probably take another few weeks to play itself out because there is still a lot of upside momentum in the Australian stock market, but the selling pressure will be vicious once the signal is confirmed.
for The Daily Reckoning Australia
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