Monthly Overview of the Major Indexes

Jun 22, 2008: 2:13 PM CST

Have you been keeping track of what the larger picture is on the charts of the major US Stock Market Indexes?  If not, let’s take a moment to see what the Dow, NASDAQ, and S&P look like on their monthly charts.

S&P 500:

The S&P is beneath its peak in 2000, and appears to be forming a similar pattern as it did before the 50% market drop (caveat – I am NOT forecasting such a drop).

Price is trapped between its key 20 and 50 period EMAs, and just a few more points lower would officially break its moving average support line, and would cause a major long-term sell signal.  With one more trading week to go in June, a monthly close beneath this zone is certainly possible, and if that happens, it would be difficult to envision many bullish scenarios that could add comfort to investors.

Although price could still find support at this level and ‘bounce’ back up, be prepared to consider shifting long-term investments should this level be definitively broken.

Also, notice the momentum divergences that preceded the turns in the market.  Volume is surging to the upside as  investors are more uncertain about what to do.  Notice also, that volume has declined on the recent upswing in price, which will likely be defined officially as a “true bear market rally”.

The chart of the Dow shows a very similar picture, only that price is actually higher than its 2000 peak.

Dow Jones:

Price is testing its key rising 50 period EMA, but a monthly close beneath this level would potentially be a significant long-term sell signal.

NASDAQ (logarithmic scale):

The NASDAQ chart looks different than the others due to the stratospheric rise of the technology stocks and the euphoria that occurred in 1999/2000.  Price is just shy of 50% of the all time closing high, and extremely unlikely to take out that level anytime soon (as in, within the next few years).

Price sits above its 50 period moving average, which has served as support ever since 2004.  Price appears likely to retest this level which is over 100 points away.

Keep in mind that I’m using a logarithmic chart for this index, so the height of the actual peak is much taller than the chart would convey.  Without using a log scale, the bottom prices looked extremely small and insignificant for comparison purposes.

A large juncture in the market is just around the corner, so be prepared to alter your strategies should the market take a turn for the worse in the near future.  It could be a harbinger of things yet to come if the charts indeed are similar to their counterparts around the year 2000.

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Probability of a String of Profits or Losses

Jun 21, 2008: 2:15 PM CST

How does flipping a coin relate to trading probabilities?  Simple, we can look at different probabilities of trading outcomes based on the distribution that results from a pure 50/50 chance outcome.

What do I mean?

Although the odds of a successful trade are rarely exactly 50/50, let’s assume that – for the moment – they are.  Let’s say you take ten trades in a row.  What can you expect to happen?

You can expect that 5 out of the 10 trades (or coin tosses) will ‘win’ (or, come up heads).  What is the actual distribution like, though?

Did you know that the odds of having exactly 5 of the 10 trades (or coin flips) win is only 24.61%?  That means that roughly 75% of the time, you’ll have a different result than what you expect!

To be fair, the probability of having 4, 5, or 6 winning trades (plus or minus 1 from the expected value) is 65%, which is in line with the standard “bell curve.”

What is the probability of having a run of 10 out of 10 trades be winners (or losers)?  It’s only 0.10%.  Rare, but it can happen.

Let’s look at the results from a randomized study I completed in Excel, based on flipping a fair coin 10 times, for 10,000 trials (something that might take months in the real world) and count the number of times ‘heads’ comes up in each of the 10 series of trials.

This will be similar to what you can expect if you took say 100 sets of 10 trades each and asked “how many trades can be expected to be winners?”

Let’s look at the distribution:

Remember, with odds of 50%, we would expect 5 throws out of 10 to come up heads.

We would expect the next most common values to be 4 or 6 throws out of ten to come up heads.

We would not expect many at all to turn up a series of 10 heads in a row (or 10 tails in a row).

Despite that, out of 10,000 series of 10 tosses, we had 10 runs of 10 tails in a row and 11 runs of 10 heads in a row.

What does this mean for trading?

If you can expect to win 50% of your trades, this would be similar to the distribution of possible outcomes, and their respective probabilities based on a series of winners or losers.  Most of the time, you’ll fall one or two values away from the expected value (exactly 5 out of 10), but sometimes, you’ll get a string of losers or winners, just through probability alone.

What will happen to the distribution when I shift the odds up to having higher odds of a winning trade than losers?  Recall that few situations produce exactly a 50/50 chance of producing a win over a loss.

Check back!

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The Arc of Opportunity is Almost Complete

Jun 20, 2008: 6:33 PM CST

What is the Arc of Opportunity, you might ask?  It’s reflective of the smooth, even transition that’s occurred recently in the Dow Jones Index.   You could name it whatever you like, actually, such as the “Arc of Shame,” “Arc of Buying and Selling,” “Arc of Transition” or whatever seems catchy to you.  Let’s look at it in its full glory.

This is a unique pattern that probably isn’t discussed in any textbooks, but the underlying logic is sound.

This represents an orderly shift from buyers to sellers in a clean, systematic way, as demand overcame supply, momentum decreased, and supply overcame demand in a rhythmic, almost ‘mirror image’ pattern.

I have been quite bearish on the short term because the potential of this situation occurring, which has played out according to expectation, but the up-days gave me difficulty in intraday trading – my bias was too strong to see how the market could go up, and that resulted in missed opportunities and small stop-outs.

We all need to learn that, even though the short term trend may be down, there is no such thing as “straight up” or “straight down.”

Nevertheless, this pattern (as I see it) is just about complete, and will terminate when price tests or breaks through the March lows.  I’m not sure what – if anything – the Federal Reserve has up its sleeve to save the market again.

In January, it was the .75 rate cut.  In March, it was the Bear Stearns bail-out and rescue.  In June, it was….

Be very careful in the upcoming weeks, and remember that volume can be lighter during the summer and moves can sometimes be more erratic.

Nevertheless, I thought this pattern was very interesting and offered a clear pathway for price, which provided good trading opportunities, once you got the overall short-term direction correct.

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VMI – A High Flyer Crashes

Jun 20, 2008: 11:08 AM CST

Valmont Industries (VMI) has been a steadily rising stock until recently, when bad news destroyed the tranquility of the recent rise.  Let’s look at the charts for some clues and educational lessons.

First, the stock broke above its downtrending moving averages in late March (double arrows), signaling strength in the stock.  The breakout from consolidation led to a higher than average trend move in the stock, which was accompanied on volume that was not as high as could have been expected.

Notice the new momentum high in late April, and the “Impulse Buy” trade that set up.  This was a textbook example of the trade, in that volume steadily declined as price pulled back to its key 20 period moving average, almost begging for you to enter the trade there and place a stop beneath the 20 period EMA.

As expected (but never guaranteed), the stock burst to life and a new trend leg up materialized.

A negative momentum divergence occurred here, as an early warning sign that the stock may have just moved ‘too far, too fast’ and that supply may be ready to come back into the market, as those traders/investors with large profits may be ready to realize those gains.

Price made a third ‘push’ up into a climax just before the surprise drop, and price has now violated its daily moving averages and the rise is potentially over for the time being.

The “three push pattern” and “triple momentum divergence” in no way forecast the shocking decline, but they were clues that buying pressure was weakening and selling pressure might be intensifying.

Let’s peek at the chart on the Weekly time frame:

The situation may not look as bad here, as we have potentially strong support coming in from the 20 period weekly EMA, the $100 per share “round number” support, and the prior resistance zone at $100 which could serve as support now.

Regardless, this stock can provide valuable lessons in its patterns, regarding range consolidation, price expansion into trends, rapid expansion, and then potential rapid contraction.

Notice also how volume has been steadily rising since mid-2007.  Whether or not you want to trade this stock, I would recommend studying its patterns for interesting insights you can use for other trading analysis.

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Sector Performance for June and 2008

Jun 20, 2008: 10:05 AM CST

What have your favorite sectors returned so far?  Let’s take a look at Sector SPDR performance both for the month of June so far and the year 2008 so far.

For the month of June:

The Financial sector returned the worst performance for June, dropping almost 13% so far.  The only sector to post a positive return for the month was Utilities, which did so just barely at 0.50%.

All other sectors returned roughly equivalent negative returns, with both Technology and Consumer Discretionary Spending losing roughly 7.5% each.

How have the sectors fared for the year 2008, now that it is almost half-over?

The Financial sector has declined over 20% so far, followed closely – and surprisingly – by Healthcare at a loss of 13%.

We hear of the “Credit Crisis” and “Housing Bubble Burst” but actually, Healthcare has posted the second worst sector decline of the year, which has escaped many media pundits.

The two best performing sectors of the year have been Basic Materials (up 7%) and – of course – Energy (up 9.5%).

Continue looking deeper within the sector trends for potentially profitable candidates to swing trade or perhaps use as a position trading vehicle.

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