Last week we released a video to Daily Reckoning readers that was my weekly market update sent to my subscribers in Slipstream and Swarm. In it I was very bearish about the immediate future of the market because the ASX 200 had fallen below the key level of 4,400.
The market has since recovered in a blistering rally that has taken the ASX 200 back up towards 4600.
So the question has to be asked. Was I wrong to be bearish? And now that the market has behaved this way, should I now be bullish?
Click here to enlarge
Have a close look at the chart above. Even open it in a window beside this article so you can refer back and forth without too much effort.
You can see that I have traced out two ranges as key to the ongoing trading in the ASX 200. Basically what we can see in the chart is that there has been a large distribution of price formed between 4,400 and 4,900 since October last year (between the solid blue lines in the chart).
Since May this year we have been tracing out another lower distribution between 4,200 and 4,600 (the solid red lines in the chart).
The lower range is, of course, related to the upper range. It is in effect a trading range around the lows of the upper distribution as the market tries to work out whether price will return to the upper range or fall over and begin trending down.
The key levels to watch in all of this are the Points of control (POC) of the structure which is the midpoints of the two ranges (I.e. 4,700 and 4,400 which are the dotted lines in the chart)
The sell zone that I have traced out in the chart is between 4,550 and 4,700. These levels are based on the 200-day moving average and the POC of the upper distribution. My subscribers know that I created that sell zone in early July before the market traded up to 4,600 in early August and then fell over to 4,313 a couple of weeks ago.
This is why we were selling stock short when the market reached the sell zone in early August.
It is trading the edges of the distribution that will make you money because you have the mean reversion towards the point of control working in your favour to put you in the money quickly. Also you only have to risk a small amount to find out if you are wrong. Therefore the risk/reward is very good.
The reason I got excited when the market traded under 4,400 a few weeks ago was that the probabilities increase that the market will trade to the other side of the distribution once the price trades under the POC. But this area is not the area where you want to be putting trades on because the risk is too high and the potential reward too small.
You have either placed your bets at the edge of the range and have taken profit near the midpoint, as we had in Slipstream, or you are going to find it very difficult to make money.
If you look at the chart again you can see that the “false break” of the POC at 4,400 that occurred a few weeks ago sent the warning signal that the buying pressure was still present when it turned and closed above 4,400 on the 30th of August and also closed back above its 10-day Moving Average.
Click here to enlarge
I have reproduced the ASX 200 chart for you with a series of ellipses showing every time the price had moved through its point of control. You can see from this chart that over the past year we saw that once the market had penetrated its POC it traded quickly to the other side of the range in 5 out of 7 occurrences. But it must be noted that the price can be volatile in the centre of the range and can make it a difficult place to trade. It is much safer to trade the edges of the range once a false break has been confirmed.
So where does that leave us now?
The short and intermediate trend have turned up now that the 10-day MA is above the 35-day MA but it has to be said that we are firmly stuck in a range at present and so these trending indicators have less predictive ability.
The larger distribution’s POC of 4,700 is a clear line in the sand for this market. If the market can trade and hold above this level then I would throw in the towel on my bearish stance and become bullish. Until that occurs I believe 4,700 will prove to be very stiff resistance.
If this market does manage to poke its nose above 4,622 in the next week or so I will be waiting for a reversal signal to begin shorting this market aggressively. The 4,200-4600 range is still the current range and the Point of Control of 4,400 will be revisited before long in my view, therefore shorting the market above the extremity of the current range is a great risk/reward trade.
The main reason for this is that a failure below 4,200 will not only spell the end of the 4200-4600 range but also the larger 4,500-4,900 range. This is the moment when stale bulls that have been holding on to bad positions for the past year will finally capitulate and the market could be a lot lower very quickly.
Shorting the market around 4,600-4,700 is a low risk/ very high reward trade.
Of course it will only be once the short and intermediate trends turn down again that the conviction on the trade will increase exponentially.
It must be remembered that we are about to enter the worst period of the year for US equity markets seasonally from 11th September on. Also large Fund Managers have only just returned from summer holidays in America and the current rally has been on very light volume. European debt problems are beginning to resurface again, gold is breaking out to new highs and the Yen is at 15 year highs and continuing to rally.
Most other markets are signalling that big investors are preparing for the US to re-enter a recession. The equity market will wake up one day and I reckon it will be within the next 2-4 weeks.
Editor, Slipstream Trader
for The Daily Reckoning Australia