Markets Close the February Gap

Apr 15, 2007: 2:14 PM CST

Friday market the official “closing” of the gap created by the “shock” decline in late February ‘07. The market is now at a technical decision node, and will either reverse off the gap closure or continue higher. Either way, there may be a technical pause at this level if traders who were trapped by the gap now use the return to this level as a “gift from God” to exit their positions, as they just suffered through pain as an investor. Of course, they may not think of this at all and continue holding unabated and relieved at the recent market strength.

The Dow closed the gap ($INDU does not officially record gaps in its price weighting)

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The Nasdaq Closed the Gap (April 13)

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I also wanted to include a couple of Weekly Charts which still (currently) show rather healthy technical uptrends.

Dow Jones Weekly Chart (April 13th)

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NASDAQ Weekly Chart (April 13th)

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Even swing traders benefit from studying the basic price action on higher time frames and sector analysis. Day traders are helped by knowing intermediate trends, but also longer trends often drive daily movement.

Best of luck this week.

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Sector Rotation Chart Apr 15

Apr 15, 2007: 11:02 AM CST

I wanted to introduce a few sector rotation analysis charts.  Sector rotation – once understood – can provide clues as to the future of the broad market, as well as opportunities for both investment, trading, and hedging decisions.

I recommend learning more on Sector Rotation, but I will be providing brief possible implications based on the graphs (all graphs courtsey StockCharts.com).

Sector Strength Line Chart – 3 Months 

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Energy, Materials, and Utilities all increased 10% from January 1st.  From a sector rotation model, this is a negative sign for the economy, as these sectors tend to outperform directly before or during a market top.  The theory states that the market cycle leads the economic cycle by three to six months, and if this is correct, we are achieving a possible peak in the business cycle.

Sector Rotation Bar Chart – 3 Months

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This chart shows the same information, only in bar chart form.  The theory states that the sectors rise (in this chart) from left to right as institutional money flows from sector to sector, based on what the general economy is expected to do, and what the climate from interest rates (cycle) is experiencing (high or low).

Money tends to flow into “defensive sectors” like healthcare, consumer staples (things we HAVE to have regardless of the economy), and Utilities (as interest rates fall) during market/economic peaks.  This is a hidden way “Big Money” protects themselves from downturns in the market.  It appears we are seeing this progression now.  Also, high energy prices tend to mark the end of market peaks because demand is high for energy, but higher prices serve as a “tax” on average Americans and businesses, cutting their bottom line and curbing spending.

Anyway, a thorough explanation of Sector Rotation Theory is beyond this blog, but I do recommend reading more on the subject.

Here is a Chart detailing a “quick study” of Sector Rotation Theory and how the Stock Market (and sectors) lead the Economic Cycle (recovery, expansion, contraction).

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I have added two arrows of possible location of the stock market cycle (sector rotation) based on the above data.  IF this is correct, it would imply a near peak for economic conditions.

One note of caution against reading too much into the model … similar patterns occurred last May (06) when the market fell 10%, and many people were calling for a recession.  However, unexpectedly, energy prices fell, tension in the Middle East (Israel) subsided, the Fed indicated it would no longer raise rates, and other economic conditions approved as the market crept higher (probably because of the doomsayers).

While 2007 might be different, I am reading into this analysis that caution ahead is warranted, BUT that underlying market prices and trends overrule any fundamental analysis.  After all is said and done, PRICE is king and there can be so much negative information out there, yet if the market continues to creep higher, all that matters is making money, and that is done by following the direction of the market IN SPITE of all the news.

Nevertheless, I don’t think this is the time to load the boat with long-term position trades, either.

Price rules and it is easier to take the market one swing or one play at a time, while viewing the underlying forces that drive price in the long term.

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Industry Flow – April 15

Apr 14, 2007: 10:29 PM CST

From time to time, I will post results of my scans regarding industry and sector analysis.

How to read these charts:

  • Colors are read from right to left as money flows into an industry (red on right to green on left)
  • The numbers – 100 for example – mean percentile of industry groups (in terms of institutional money flow)
  • The implications are that industries that are strong will remain strong (and vice versa)
  • From industries, you will examine leading stocks and study possible relations among groups

First, the Top Industries (in terms of institutional money flow) over the last three months:

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Processing Systems has been in the 100th percentile for the last three months, followed by Life Insurance.

Next, the Bottom Industries in terms of money flowing Out of the industries:

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Aluminum, Residential Construction, Building Materials, and Home Furnishings have been in the bottom percentile over the last three months.

Also, the industry analysis can be used to identify money flowing into or out of an industry group:

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In this case, we are viewing money flowing OUT of these industry groups – remember, the chart is read right (past dates) to left (recent dates).

Often, you can find some stealthy trade candidates beginning new uptrends or downtrends before they become at the top or bottom of industry leadership (read “Before the herd catches on”).

Weekends are great times to study the broad market and also sector and industry institutional money flows (and analysis) to set up swing-trade or position trade candidates, provided the stocks have chart patterns or price performance (trends) you are comfortable trading or investing.

Industry Analysis Charts provided by Prophet.net.

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Link: Thoughts on Moving Averages

Apr 14, 2007: 5:25 PM CST

I absolutely use Moving Average analysis in my trading, and – although there are hundreds of articles that address the topic – I found two recent posts in the blog world to be interesting to me.

First, let me preface: Moving averages – like every other indicator – “work” because people respond to them, and when people do so in aggregate, the combined imbalance “causes” them to “work”. Moving averages work best in trending markets, and can be used to define a low-risk entry into a trending market (following a pullback).

Here are a few quotes from an article from the DayTradeTeam:

“One of the biggest reasons moving averages are so popular as trend-following systems is that they embody some of the oldest maxims of successful trading. They trade in the direction of the trend, and moving averages let profits run and cut losses short. These principles of the moving average force the user to obey the rules by providing specific buy and sell signals.”

Richard at MoveTheMarkets posted an insightful analysis arguing against “magic moving averages,” and the entire post is absolutely worth a read for deeper study. I have included a few quotes:

  • Math doesn’t support stocks – people do.
  • The only reason moving averages work at all is because enough people are using them as guidelines.
  • Most stocks are just too fickle to trend along a single intraday moving average for long.
  • People support stocks. That also tells me that there’s no reason to tie yourself down to any “magic” moving average period.

I have learned that Richard is right in my experience. In the past, I used to enter trades because of a pullback to a key moving average and place my stop right below them. Invariably, I would get stopped out right before a major move and then curse the market makers, stock, or anything I could find for gunning me out.

I then realized that moving averages are not magic, and I cannot expect price to reverse the moment they touch the average without at least some wiggle. They can still be used for entries into a trending market, and they often work fine at this, but do not approach “moving average support” as an exact science. In fact, approach nothing in technical analysis as an exact science, but that it reveals probable tendencies of sometimes irrational people. Again, know why you take the trades you do and what the “trade idea” you are executing means.

If you don’t use moving averages for trade entry, you can still benefit by using them to identify a trend condition in the market. Identify whether or not price is above or below a major moving average. This adds information to your analysis. Some traders refuse to go long when a stock is beneath the 200 day moving average on the daily chart. Others use “Moving Average Ribbons” to identify the trend/range axis or picture of the market.

Again, don’t expect price to behave because a certain technical condition is met. Understand the reasons behind “moving averages acting as support” and what that might mean for you and your system as a trader.

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Link: Different Types of Traders on a Chart

Apr 13, 2007: 1:12 AM CST

From the Traders Action Zone, the author writes a brief post regarding the TAZ strategy, but of great importance for my focus here is the areas and confluence of different types of strategies and traders all on one chart. Think about how different traders and strategies create the aggregate charts we see.

The author (Craig) utilizes a chart and notes the subsequent trend and describes where position traders, swing traders, momentum traders, and (gasp) day-traders “do their business” on the chart at certain zones.

Not to get you too hyped up, Craig throws cold water on your developing, greedy ambitions with this statement:

There isn’t ANY trading strategy that will make you a consistently profitable trader. Sorry to disappoint you. The only thing that will enable you to consistently pull money out of the markets is YOU.

YOU must have discipline. YOU must be able to take losses. YOU must be able to take your profits. YOU must eliminate fear. Put simply, you must be able to control the emotional and psychological problems that prevent success.

That will be your biggest challenge in learning how to trade stocks with any strategy.

That’s really the secret, but new traders don’t want to hear that there is no magic strategy or magic indicator that can make your wildest dreams come true.

On another post, the author describes any swing trader’s core strategy specifically as:

…trying to identify when there is a transition from sellers to buyers (long) or from buyers to sellers (short).”

I thoroughly enjoy many of the other posts and easy to understand concepts on the site.

Next time you review a chart, think about where different types of traders see opportunity and where others see risk based on their overall strategy and see where you fit in the (chart) picture.

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