Technical analysis is centered on the notion that a chart represents a complete reflection of all fundamental and technical data relating to a stock, a sector, or an index. For the better part of half a century, technical analysis was mostly about patterns like triangles, channels, heads and shoulders, etc. With the advent of computers and a proliferation of charting software, pattern recognition continues and is heavily augmented with derivative indicators such as stochastic oscillators, moving average convergence divergence (MACD) and numerous others. In fact the proliferation of indicators borders on incomprehension anymore with new ones popping up seemingly weekly. I term this genre of patterns and indicators "classical TA."
Although each pattern and indicator can have its moment in the sun, the market is not static and the patterns and indicators many times simply do not work because their underlying assumptions do not reflect the reality of the market at that particular time.
What always works is what you want however, and a fundamental problem with almost all classical TA is that it doesn’t address nor sufficiently recognize what fundamentally moves markets: supply and demand. Unless there is a greater demand than supply, then price will not move higher and vice versa.
So the real question is how to spot supply and demand and use it as part of your analysis. I do this through an approach termed "neoclassical technical analysis." It is TA that is beyond
the classical approach, and what’s better, it has very few rules and is simple to understand and monitor.
So where are the markets when viewed through a neoclassical lens? By looking at just two broad indices I believe we can get a very good indication of where we are and what is happening right now. Here’s the S&P 500
(INDEXSP:.INX) and the Russell 2000
(INDEXRUSSELL:RUT) as viewed through the iShares Russell 2000 ETF
The first thing to notice is the divergence -- the S&P 500 is stronger than the IWM. This is an indication of a more risk adverse posture by market participants. That is true in the relationship between these two charts and also true of the relationship inside the S&P 500 where the safety sectors like consumer durables, health care and utilities are the leaders. They are late cycle sectors, not early, so they too are saying market participants are choosing to be cautious -- still long, but cautious.
The second thing to consider is that today and this week is a day and a week of tests. Both the small and large caps are testing their respective resistance zones. These anchored resistance zones reflect areas where market participants should show up to sell their wares. It doesn’t mean they will, but they should. By monitoring the test of these price zones one can get a sense of what comes next. Typically if volume expands and highs are surpassed then there is a high probability that the trend that has been in place will continue. If not, then not. In that case, a range-bound market could continue or selling pressure may finally emerge.
It is this latter thought that requires a bit more examination, for we need to understand where we can expect the trend to change from bullish to at least sideways or potentially bearish.
Looking at the S&P 500 chart once more, you can see the two swing point lows clustered just below Friday’s low. To change trend to sideways, those lows are the target. The fact that there are two of them clustered together makes a break a bit more problematic and likely to carry. If that happens, I would expect the S&P to do a quick push lower into the low 1520s.
Glancing back at the IWM chart, note that it has already broken a swing point low and actually is in a suspect sideways trend at this juncture. Again, this is a reconfirmation of the relative weakness of the small caps to the large. The Russell is the most important index to monitor. It is the one that led us higher over the past four months. It has been the first to turn. It is telling us that supply is greater than demand at these price levels. If that failure actualizes then the Russell will fail at these price levels and that will lead the other indices lower as well -- reluctantly as always, I suspect. That’s what I expect to happen near term.
No positions in stocks mentioned.