Thursday Morning Check on Stock Market Internals

Oct 20, 2011: 9:53 AM CST

With US Equity Indexes threatening a breakthrough above key overhead resistance, what are market internals hinting about the current state of the market and the strength of the recent rally?

Let’s take a look, starting with the 10-min chart:

We’re seeing the “Big Three” market internals – Breadth ($ADD), NYSE TICK, and Volume Difference of Breadth ($VOLD).  Internals allow us a chance to look ‘under the hood’ of the market to peek at underlying strength or weakness that we can’t get from price alone.

So what’s the signal?

Internals are NOT confirming the move up, which is a caution sign.  This is NOT a sell signal, nor does it mean that price cannot breakthrough resistance (it can), but internals suggest a downward move or consolidation is the most likely (but not guaranteed) next move.

Digging a little deeper, we see that the “Big Three” internals peaked with their highest recent levels on October 10th during the middle-part of the rally off 1,100.

The rule is – market internals tend to be STRONGEST at the START of a market movement (swing) and then decline (diverge) towards the END of a move (swing).

It’s thus important to note key (obvious) divergences in Market Internals and Price… which is the case from October 18th when price initially broke the rising trendline… yet market internals showed a positive divergence (NOT confirming the break).

You can see how price rallied higher on the “Bear Trap” or failed break on the 18th.

Speaking of Traps, let’s pull the perspective back to the 30-min chart and get a bigger picture on internals:

Keeping with the “Bear Trap” theme, you can see in the highlighted region that all three Market Internals formed Positive Divergences on the breakdown under 1,100.

In this sense, Internals showed hidden/secret STRENGTH while price showed a clear weakness/breakdown.

The result?  A powerful short-squeeze and feedback loop propelled price to where we are now – battling overhead resistance at 1,230.

Let that example be a lesson in the importance of Market Internals as confirmation/non-confirmation.

Anyway, the bigger picture shows us the initial strength in internals off the Bear Trap lows, peaking as mentioned on October 10th.

What we’re seeing now is an overextended rally into overhead resistance as Market Internals signal caution with divergences.

Nevertheless, any firm movement above 1,230 should trigger another powerful short-squeeze/’popped stops’ feedback loop breakout rally (short-squeeze) no matter what any indicator says, so be on guard for that potential outcome.

Otherwise, continue watching the current situation to see if there is a confirming trigger (sell-signal) from price (which argues for bearish plays) or if there is any sudden strengthening in Market Internals, especially on a breakthrough above 1,230 or higher.

“IF/THEN” logic works better than blind reliance on any indicator (even internals).

Corey Rosenbloom, CMT
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