Signs of Hope

U.S. equity indices have traded in a choppy, sideways trend for the first 4 days of this week as the clowns in Washington D.C. consider exactly how badly they want to screw up the economy for 2013 while debating the fiscal cliff.

This day-to-day back and forth between the 2 political parties probably makes for good ratings for financial TV, but it roils the markets.  So after the markets put in deep "V" patterns recently, this uncertainty has lead to a period of sideways to slightly downward trading in markets this week.

These deep "V" patterns are not the typical action you like to see at market bottoms.  As I mentioned in my last post, I'd rather see some sideways backing and filling as the markets try to stabilize and form a new base for a move higher.

Despite it's choppiness, as I see it,  the trading so far this week is actually constructive.  It has many traders skittish and worried, and many of them on the sidelines.  It has allowed for some profit taking after the sharp run up off the lows.  And it keeps the traders that actually are trading in a very short term frame of mind.

All of these things add fuel to the fire for a rally if the indices move above recent resistance areas.  For the Russell 2000 (IWM), the first key level is at the $83-84 area.  For the Nasdaq Composite (COMPQ), the first key level is 3050-3100.

One thing I've noticed is a subtle positive divergence developing in RSI 14 readings.  As the chart of IWM shows, the recent reading is higher than they were at previous 3 recent higher price areas.

This first chart is from August 2 when I put it on Twitter.  It shows the important level that needed to hold for the rally to continue, and it did.  The recent bottom in the IWM came down to that exact same level.

Click on charts to enlarge:

 The second chart shows my current take on IWM.

Another interesting development is the surprising recent strength in the financials (XLF), primarily in BAC and C.   This may mean that trader's concerns over the fiscal cliff are exaggerated at the moment.

Ideally, I'd like to see the market continue to trade sideways and chop around for a bit.  This would allow for some market leading stocks to tighten their bases and offer better entry points.

So while traders have to be prepared for all scenarios, recent action is somewhat encouraging.

Still a Tricky Market

It's been 2 weeks since my last blog entry that suggested traders wait for a valid 'follow through day' (FTD) before making large commitments to the market. 

The scenario of a reflex rally was mentioned as a good possibility, and indeed we got one as the U.S. market indices rallied strong in the Thanksgiving holiday shortened week.  Although not surprisingly, trading volume declined significantly.

Readers of Investors' Business Daily know that the paper placed the market back into a "confirmed uptrend" mode after the trading on November 23, the day after Thanksgiving.  Despite the lower volume on that day, IBD said that the run rate for the shortened trading day was ahead of Wednesday's volume. 

So despite my skepticism on IBD's market call, it doesn't really pay to quibble as to whether a half day's trading constitutes a valid FTD.  Rather, I look to see how the leading stocks in the market are trading and if there are a growing number of stocks breaking out from proper base formations.

What is happening in many cases is that leading stocks are poking above their proper pivot (buy) points, then quickly reversing back into their base, which leads to a stop loss getting hit.  Then in some cases, a week or more later that stock will move out of its base and make a decent gain. 

If you've played any of these types of stocks and were stopped out several times, it can make you reluctant to keep going back into the market looking for setups. 

Sturm Ruger (RGR) the gun manufacturer, is a good example of what I'm referring to.  After making a monstrous 12 fold advance from its November '08 lows up to April of this year, the stock dropped 41% in the next 6 weeks. 

RGR bounced back in June and July, then formed a handle in August and the first few weeks of September, before attempting a breakout in the 3rd week of September.  The stock quickly reversed and fell back into its base.

RGR then spent the next 8 weeks tightening up in a 2nd attempt at forming a handle, and briefly poked above it in the 1st week of November.  But this attempt at a breakout also failed, and the stock fell back 9.5% from those highs.

Finally, the stock broke out for good on November 21, but even then a trader would have been worried as the action on that trading day left the stock off its highs, right in the middle of the day's range.

The daily and weekly charts detailed below show what I've described. (Click on charts to enlarge)

The 3D printing sector lead by Stratasys (SSYS) and 3D Systems (DDD) has been at the top of many trader's lists as this exciting new technology continues to gain traction, but DDD has a similar pattern to what happened in RGR.

DDD first tried to break out in early November after forming an 8 week cup, but quickly dropped back into its base the following week.  Then it made a second stab at a breakout in the 2nd week of November, but came under selling pressure as the general market sold off.

After pulling back into a deep handle, the stock rallied off the November 16 lows and ran straight up into new highs.  But once again, the stock sold off last Thursday and Friday and fell back into its base. 

So many traders who use 8% (or less) stop losses have been taken out of this market leader on 3 separate occasions in the last 5 weeks.

SSYS broke out on November 21, and so far has been able to stay above its breakout price of $69.08.

As we stand now, the broad market indices have formed deep "V" formations off the November 16 lows, and have surprised many traders by their continued strength without much of a pull back, aside from the early day weakness on Wednesday of last week.

These types of "V" formations are not ideal for most traders, as in many cases it doesn't allow stocks to form proper bases.  Areas of backing and filling give stocks a chance to digest their gains, and allow stocks to make more sustainable moves. 

Traders who buy a stock moving straight up off the lows without a proper pull back usually are setting themselves up for a quick loss once the stock does meet some selling.  It's best to be patient and pick your entries very carefully.

What you don't want to do is become complacent in continuing to cut your losses.  This frustrating pattern of stop/start breakouts shows a market that is uncertain and tentative. 

For now, keep positions sizes smaller and watch for more market leaders to break out firmly above their basing patterns.