Market Fades – Natural Pullback?

Jul 10, 2007: 8:14 PM CST

Today’s market action shouldn’t have surprised active traders.  Why?  The indexes were showing short-term overbought conditions as well as an overextension in oscillators, combined with the testing of a newly established trading range (upper boundary).  Volatility bands also showed odds strongly favored a retest of the midlines.

It is frustrating for new traders to accept the reality that has been summarized in the statement: “The market takes the escalator up and the elevator down.”  What this means is that losses tend to accelerate more rapidly (sometimes even in one or two days) than market gains, which often happen over small ‘chunks’ over many days.

dow-july-10.jpg

I have added a bit of trendline analysis to the Dow chart above.  The Dow hit upper resistance at the formerly established rising trendline which was violated at the end of June.  Just like support/resistance, trendlines, once violated, tend to serve as the opposite force – this is a good educational example of this phenomenon.

We are also seeing a marked sell divergence in momentum and price, indicated by the falling trending in the 3/10 oscillator.  Keep in mind that the market has rallied sharply since March, and a pause or correction is healthy and expected.

nas-july-10.jpg

The Nasdaq is showing a similar pattern, with the exception that the index made new price highs as well as new momentum highs.  A natural pullback is expected.  Shorting the market at the doji which formed at July 8th’s close was a very high probability trade:

  • A doji shows indecision, and often leads to short-term reversals of momentum
  • A test of the upper Bollinger Band in a range-bound environment signals a near 90% chance of a decline in price
  • Price-based oscillators (stochastic/RSI – not shown above) were showing overextended buying readings
  • Price was clearly extended above the rising 20 period moving average

The day’s market decline from overbought technical conditions was attributed to ‘jitters’ in the Retail Industry and fears over declining earnings.  Also, Chairman Bernake recently stated that “Inflation will be less sensitive to energy prices” which should be comforting to investors.  A reminder – inflation pressures can take hold very rapidly with exogenous shocks, such as key embargoes or attacks on supply.

Keep vigilant  and keep studying.

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