ChartWatchers

Hello Fellow ChartWatchers!

Today I want to answer a question that we get frequently - "Where do I start?  This is all so overwhelming!"

The answer is, you start with John Murphy's 10 Laws of Technical Trading.

In anticipation of your next question, here and now I present to you <fanfare> "John Murphy's Ten Law's of Technical Trading" with my strong recommendation that you read (or re-read) them and take everything in them to heart.

- Chip

John Murphy's Ten Laws of Technical Trading

1. Map the Trends

2. Spot the Trend and Go With It

3. Find the Low and High of It

4. Know How Far to Backtrack

5. Draw the Line

6. Follow that Average

7. Learn the Turns

8. Know the Warning Signs

9. Trend or Not a Trend

10. Know the Confirming Signs

"11."

Previous messages showed the upside breakout in the Dow Transports (over their summer high) which confirmed a previous upside breakout in the Dow Industrials and constituted a Dow Theory buy signal (see circle). Both Dow averages are approaching another test at their spring highs. Needless to say, the ability of both Dow averages to clear their spring highs is necessary to keep the new uptrend going. I'm going to focus today on what I consider to be the most economically-sensitive part of the transports which are the rails. Chart 1 shows the DJTA iShares (IYT) testing its May high near 86. Rails have the strongest IYT weighting at 29%, air freight is second at 23%, truckers are third at 21%, and airlines at 8%. Rail dominance is further demonstrated by the fact that four out of the top ten IYT holdings are rails. Transportation stocks are considered to be economically-sensitive because they move goods throughout the country. The two groups most often used to move that traffic are rails and truckers. Chart 2 shows, however, that rails (black line) have been much stronger than truckers (blue line). One reason for stronger rails is that they're less fuel-sensitive than truckers. Another is that rails are the primary mover of commodities like coal and grains which have been very much in demand. In a sense, it could be said that rails are another way to play rising commodity markets.

Even though stocks are overextended after a massive seven week run, we have yet to seen any evidence of weakness that would signal the start of a correction or pullback. Many momentum oscillators are also at or near overbought levels, but cumulative indicators, such as the McClellan Summation Index, continue moving higher to capture the current uptrend.

Think of the Summation Index as the smoother cousin of the McClellan Oscillator. Basically, the McClellan Oscillator equals the 19-day EMA of Net Advances less the 39-day EMA of Net Advances. Like MACD, it captures momentum by taking the difference of two moving averages. This indicator oscillates around the zero line as momentum shifts for Net Advances. The Summation Index is a cumulative McClellan Oscillator. As a cumulative indicator, it is smoother than the McClellan Oscillator and has fewer crosses above/below the zero line. It also trends.


Click this image for a live chart.

The charts below show the Summation Index with a 5-day EMA to identify upturns and downturns. This may seem like a tight moving average, but the Summation Index is already smooth and this short moving average identifies the turns pretty well. Notice that the Summation Index moved above its 5-day EMA in early September and remains above this moving average. There is no questioning the uptrend in the Summation Index. As long as this breadth indicator remains above the 5-day EMA, I would expect the current rally to continue, even if conditions are overbought. A break below this moving average would signal weakness in breadth that could give way to a correction or pullback in the market. The second chart shows the NYSE Summation Index ($NYSI) with similar characteristics.


Click this image for a live chart.

A subscriber had some questions about the Percent Buy Index (PBI) versus the Bullish Percent Index (BPI). The PBI is my creation, and it tracks the percentage of Price Momentum Model (PMM) buy signals for the components in a given index. (In the case of this discussion we will be looking at the PBI for the S&P 500 Index.) The BPI was, I believe, created by Tom Dorsey, who is a highly regarded expert on point and figure (P&F) charting. The BPI tracks the percentage of P&F buy signals in an index.

To clarify, as far As I know the BPI was introduced long before we got the idea for the PBI, but we started collecting data on the OEX PBI many years before we even heard of the BPI. I think that is called "reinventing the wheel." Nevertheless, there are significant differences between the timing models that drive the BPI and PBI.

As I said before, the BPI uses buy signals generated on P&F charts. I'm not going to go into how P&F charts are made, but suffice it to say that they are nothing like a standard bar or line chart that we normally use for charting, nor are the buy signals they generate. I don't use P&F charts because I don't find them intuitive enough for me, but many people do use them with great success, and more power to them.

The Price Momentum Model (PMM) uses ten percent price move and 200-EMA crossover to generate buy signals (see our Glossary article).

On the chart below we can see how both have performed over the last three years. I think they are remarkably similar, except for the period I have highlighted in the red rectangle, which was during the last six months of the bear market and prices were getting thoroughly hammered. As you can see, the BPI was quite volatile, showing a spike of over 70% of buy signals well ahead of the final price low. Conversely, the PBI correctly stayed flat during that time and did not start a strong up trend until the final price low was in place.

As I have said many times, every mechanical model has its weaknesses, and in this case we can see the weakness in the P&F model. Specifically, expect volatile signals during periods when there is severe price decline -- the P&F model apparently triggers too easily in these circumstances.

We use a PBI 32-EMA crossover to generate buy and sell signals, but the PBI has a finite range, and these crossovers will generate some noise when the PBI is near the top or bottom of its range. It is most reliable in generating buy signals from the bottom to the middle of its range.

Currently, both the PBI and BPI are becoming overbought. If we are in a condition similar to what we were in mid-2009, I don't think that will be a problem. In other words, the indicators can remain overbought for some time while prices move higher.

Conclusion: The PBI and BPI have a similar objective of tracking the number of buy signals for the components in a given index, so we can estimate the kind of participation is behind price moves. The PBI seems to be more stable, particularly during severe price declines.

I spend a great deal of time evaluating the financial sector because I believe it's the most influential group in terms of leading the market.  Financials underperformed miserably in 2007 and 2008 and overall market performance followed suit.  In 2009, financials outperformed and the market recovered a lot of its prior losses.  But in 2010, the market doesn't quite seem to know what to do about the lagging financial sector.  Year-to-date, our major indices are up as follows:
 
Dow Jones: +6.09%
S&P 500: +5.48%
NASDAQ: +8.80%
Russell 2000:  +12.44%
 
The financials?  Well, the Dow Jones US Financial Index ($DJUSFN) is roughly 1% higher, badly lagging the major indices.  Take a look at the chart below and you'll see another failed breakout attempt in this sector:

The financials performed extremely well from February to April of 2010 and the overall market did very well also.  Since April, however, the financials have performed miserably.  Yes, our major indices have had their moments where we've seen straight up moves, but the overall direction since April has been sideways at best.  In my opinion, the market is awaiting leadership from financials and if last week's initial reaction to JP Morgan's (JPM) earnings is any indication, the market may not like the kind of leadership it's about to get.  Financials had an opportunity to seize a major breakout and they simply choked.  Foreclosures, high unemployment, sagging consumer confidence, etc. are taking their toll on this sector.
 
Google (GOOG) provided a huge lift to the NASDAQ, especially the NDX, last week based on its blowout earnings, but I do not believe these types of gains will be sustainable if the DJUSFN cannot break that 271 resistance level.  Believe me, there are no clearcut signs in this market.  Several indicators say BUY, but many others say SELL.  Certain indicators, like the MACD, are suggesting this rally has a long, long way to go potentially.  Before I buy into that theory, however, I want to see a technical breakout in financials.  A close above 271.00 on the DJUSFN and 48.10 on the Bank Index ($BKX) would provide a HUGE boost to our major indices.  Should the financials actually begin to gain strength, we're keeping a very close eye on an insurance stock that could be poised to make a nice run to the upside.  We're featuring it as our Chart of the Day for Monday, October 18, 2010.  CLICK HERE for more information.
 
Market timing could be an issue soon as well.  September 2010 is now in the record books, defying historical bearish trends for that month.  While the September 2010 gains were the strongest September gains since the 1930s, we still need to take a step back and objectively look at the big picture.  Despite a great September, that months still looms as the worst calendar month of the year, and it's not even close.  Now we are quickly approaching the single worst week of the year historically.  The stock market's historical tendencies are the subject of our next Online Traders Series event, scheduled for Monday, October 18, 2010.  I will discuss, in detail, the upcoming bearish period that has produced MINUS 53.82% annualized returns over the last six decades, and share other remarkable statistics about historical trends that can help in your trading.  For more details, CLICK HERE
 
Happy trading!