ChartWatchers

Hello Fellow ChartWatchers,

We're taking a break from our on-going Technical Analysis 101 series to give you an update on the two disruptions that happened last week.  I want to make sure everyone understands what happened and what we are doing to prevent it from happening again.

In case you missed it, on Wednesday, September 9th, our main connection to the Internet was cut.  Around 4:45pm Eastern, "some guys" working in a manhole cover outside our offices damaged our fiber cable which knocked us off the air.  (I actually spotted those workers as soon as the problem occurred and I went over as asked them if they had touched our cable.  Unfortunately, they lied to me and said that they didn't.)  Compounding things, the true nature of the problem wasn't obvious for several hours and we had to try and eliminate several alternate theories before we discovered that the cable had in fact been damaged.

After nine hours of testing various theories, we gave up on the fiber cable and moved our site back onto the four T3 connections that - luckily - we still had available.  As a result of the nine-hour outage, we gave existing members a free week of additional service.

The following Monday, our index data vendor ThomsonReuters stopped providing us with data for the S&P 500 index along with about 10 other important CBOE-based indexes.  The problem was traced down quickly, but Thomson did not re-enable that data for us until after the market closed.

Both of these issues are completely unacceptable.  Here's what we are doing to prevent them in the future.

1.) The Gigabit Fiber connection has been fixed.  We hope to move our Internet traffic back onto that larger, faster connection Monday evening.

2.) We have ordered a second Gigabit Fiber connection that uses a different physical path so that if one connection gets damaged, the other will continue to work.

3.) We are installing additional physical protection devices for our cables down in the conduits next to our building.  We are also trying to track down "those guys" who caused the problem and recover some of our costs.

4.) We have purchased a second router and fiber-optic interfaces to act as backups for our primary equipment.

5.) We are moving our primary data source for CBOE index data from ThomasReuters to IDC/Comstock this week.  We are also expediting our entire move off ThomsonReuters as a primary data provider although that process will still take time.

6.) We have sent letters of protest to ThomsonReuters and CBOE about their vague and contradictory communication policies.  Unfortunately, we don't have much leverage with those huge companies - which is part of the core problem.

When we do have disruptive problems like this, we will try to communicate as much information about them to you as we can via our Status Blog.  Make sure to check that blog whenever you experience a problem accessing our charts.

Arthur Hill reviewed some standard intermarket relationships on Thursday. One of the best known is the inverse relationship between the U.S. Dollar and commodity prices. That's why a falling dollar has had a bullish impact on commodity prices since the spring. The falling dollar has also boosted global stocks as money moved out of that safe-haven currency into riskier assets like stocks. But not all stocks rise equally at such times. A falling dollar has a much more bullish impact on foreign stocks. Since the March top in the dollar, for example, the S&P 500 has risen 56%. Foreign stocks, however, gained 72%. The stronger foreign performance was due largely to the falling dollar. The red line in the chart below is a ratio of the Morgan Stanley World Index (Ex USA) and the S&P 500. The green line is the U.S. Dollar Index. The inverse relationship between the two lines is very clear. Foreign stocks did much better than the U.S. from 2002 to the end of 2007 while the dollar was falling. Foreign stocks did much worse than the U.S. during the second half of 2008 as the dollar rallied. The dollar peaked in March of this year and has been falling since then. The rising ratio shows foreign stocks outpacing the U.S. since the dollar top in March. A weaker dollar favors heavier exposure in foreign stocks. The direction of the dollar also determines when it's better to use foreign ETFs.

For weeks we have been looking for a correction, and a time or two we experienced some trepidation that the bull market might be over, but all the market has done is produce a series of minor pullbacks. At the present it is trying to break out of a rising wedge formation, the opposite of what we normally expect with a bearish formation. This kind of behavior continues to supply us with evidence that bull market rules still apply. That means that we should continue to expect bullish resolutions rather than bearish ones.

Market internals have continued to remain overbought. For example, the PMO (Price Momentum Oscillator) on the above chart is near the top of its normal range. On the chart below we see three indicators representing the ultra-short-, short- and medium-term time frames. You can see how they have all reached overbought levels and topped. In a neutral or negative market, this would present a great sell signal, but you can also see how twice before these conditions failed to produce any serious decline. Perhaps the third time is charmed?

Bottom Line: Many market indicators are overbought and topping, presenting us with yet another setup for a correction, but bull market rules say we shouldn't count on it. A small pullback is more likely. To be sure, our bullish assumptions will ultimately prove wrong when the final top of this rally arrives, but our trend following models keep us from pulling the trigger prematurely. We remain on a 3/17/2009 medium-term buy signal for the S&P 500.

In a perfect world, we'd all invest every dime in winning stocks each and every trading day.  Unfortunately, I haven't seen that kind of trading world yet.  So as we approach each day, we must assess the risks in the market and determine an appropriate trading strategy.  At times, it makes good sense to go "all in".  But most of the time, the nature and size of our trades should be based on the risks inherent in the market.  I've discussed some caution of late and I maintain it.  It doesn't mean the market cannot go higher and that you cannot trade on the long side.  It simply means you should do so much more selectively and with stops in place.

The good news is that price/volume trends remain very strong and this indicator is the most important of all, bar none.  There's a laundry list of negatives that we must respect though.  The MACD has been negative on the daily chart across all of our major indices for the last 3-4 weeks.  There's also a negative divergence on the 60 minute charts, as the NASDAQ chart below shows:

Stochastics and RSI are both near-term overbought across our indices as well.  They could use a pullback to help consolidate recent gains.  Without a pullback, the overbought conditions last longer and generally encourage a steeper selloff when one finally occurs.  I'd prefer to see a little unwinding of these oscillators now rather than later.  Historically, we've entered the third worst period of the year on the S&P 500.  Only one week periods in October and July have produced worse results historically than the period we're in.  So far, this period is holding up well, but we have another week or so to negotiate before we can call it a success.

Finally, and perhaps most importantly, the masses are jumping into equity options on the call side.  This is a MAJOR warning sign to me as retail traders, unfortunately, rarely walk away with the pot of gold.  The Friday that options expire usually carries very heavy volume on both the equity call and equity put side.  I tend to follow the equity call and put activity on days other than option expiration Fridays.  In early May, I saw record levels of equity calls traded.  In fact, May 7th (this day marked the top for awhile) held the record for most equity calls traded on a non-option expiration Friday.  When longs start to believe the market cannot go lower, it does.  The May 7th record of equity calls traded was broken this past Wednesday, September 16th, then challenged again on Thursday.  I'm seeing way too much complacency in the market.  I've seen many in the media saying that no one believes the market can go higher, therefore it will.  While that's nice to say, I simply can't find proof of that by looking at options.  I'm seeing the exact opposite - equity option traders don't believe the market can go DOWN.  That ALWAYS makes me nervous.

Can the market go higher from here?  Absolutely, and without a trace of pullback too.  Overbought can stay overbought.  There are NO guarantees in the market.  Would I be "all in" expecting that continued bullish behavior?  Absolutely NOT.  The risks are too high.  I believe you have to be very, very selective in trading the market at this level.  While shorting has been a practice in futility for several months, the money has been made on the long side during this stretch.  I continue to look for the stocks with the very best volume trends, suggesting accumulation.  The best time to enter those stocks is either just as they make a new breakout on confirming volume OR on a pullback to retest a previous breakout level or a major moving average.  Personally, I prefer the latter as risks are better and more easily controlled.  One feature that we've added at Invested Central over the past 6-7 weeks is a Chart of the Day.  These charts are designed to be highly educational and they focus on finding candidates that possess many of the reward to risk characteristics that I look for.  You can check these charts out daily at CLICK HERE.

During our national radio broadcast, we discuss the Chart of the Day as well at 8:42am EST.  CLICK HERE to follow us LIVE on the air each and every trading day from 8:00am-10:00am Monday thru Friday.

Happy trading!

The insatiable need to own stocks has manifested itself in most S&P sectors, in which the Consumer Discretionary sector is doing far better than anyone can believe. Most, if not all of the clients we speak with on a daily basis do not understand why this is so; they note that they and and their friends and neighbors have pulled back, as well as deleveraging is the order of the day. Therefore, why then, have we seen 75% move off the low in the Consumer Discretionary ETF (XLY)? Quite simply...liquidity.

But having said this, we think the liquidity is going to slowly, but surely dry up as the animal spirits of the "chase" for XLY come to an end. Traders and investors alike will look around them and ask why XLY is so high, and how did it get there? For us, we find the technicals behind a potential short-trade rather "good" at this point, for prices have rallied back to major overhead resistance at the 50% retracement levels off the lows. Too, prices into 120-week moving average resistance with the 30-week stochastic at overbought levels. This seems to us to be a low risk/high reward setup, but it is really only a matter of short-term timing in which to be short XLY. In our opinion then, lower prices are ahead; with our target a simple 50% retracement of the rally back towards the $22 level.