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The Morning Cup of Jo


"Sign, sign, everywhere a sign... do this, don't do that, can't ya read the sign?"


Trademark Pending

Greetings once more from Ollie's Diner and welcome to another 'Morning Cup of Jo.'

In last Tuesday's 'Jo' I discussed the concerns I had with the potential bottoming patterns apparent in the three sisters. One of my concerns was how the stochastic on all three charts was showing a "new" extreme reading, which is not indicative of a final bottom before a trend reversal. On Wednesday I followed with a 'Jo' that gave a more palpable outcome for the markets, given the condition of the momentum indicators and evident contrary technical patterns.

As we saw on Friday, with the meager Non-Farm payroll number, the markets broke free of their seemingly everlasting trading ranges. Now the question stands, "What's next for the markets?" First we'll take a look at a shorter-term chart of the SPX. On Friday around 1:00 I put out a Buzz stating, "If this morning's horizontal support is broken I believe 1,060 is the next stop on the SPX over the next few sessions." Who knew we'd see it that afternoon. Anyhow, the two converging (RED) trend lines are where that number originated from. However, to further the discussion about Stochastic Divergence and being able to read the Road Signs, I've put a few other comments on the chart.

The first issue I'd like to cover is the stochastic reading at the end of July. When the market hit support at 1,080 the fast and slow stochastic were both showing a reading of 2. I find this number to be very important when determining a potential bottom and/or turn. Before continuing let me say this, "The stochastic is probably one of the most misused secondary technical indicators there is." The reason? Simple. The belief is that when the stochastic reaches an oversold level, the market - or equity - is likely to turn. What makes the stochastic so confusing is that statement is partially true. However, if it is used solely for that purpose it can create many false-positive readings. I can't tell you how many times the stochastic has crossed, when below 20, to come back above the oversold line and does nothing more that leads investors into a false sense of hope that is soon shattered by another turn south within a few weeks.

Over the many years of using this indicator I have found it only useful - having the highest probability of a positive reading (correct outcome) - when looking at and understanding the divergence theory. Before going onto divergence there is another point to be made, which relates to the aforementioned low reading in the stochastic back in July. When the stochastic shows an extreme reading, and I'm not talking about the below 20 line, I'm referring to being below 3; this becomes a new ballgame. When this happens the likelihood of a retest or undercut in price is massive. Whether it's in a week or a month, the probability charts go off the wall. Also on a side note, if the stochastic reads one or less as the market is changing trend, the odds are this trend change will be sustained until a divergence occurs and is not meant to be read as a bottom, but as a new trend ensuing.

Onto the main reason why this secondary momentum indicator is my preferred way of looking for market/equity tops and bottoms - divergence and its success rate. First of all, I believe this is one of, if not the only, way of using the stochastic because of its unreliability when just using the crossover signal. Divergence is very simple and that's just the way I like to keep things - simple. Divergence occurs when the price drops to a new reaction low and the stochastic does not. See, I told you it was simple. However, ya gotta wait for the second cross. For example, in the chart above, just because the stochastic is not showing the same extreme reading as back in July, doesn't mean there is divergence. You have to wait until the second crossover. At that point you have a more reliable bottom.

One last note about the SD and I'll leave it alone. Make sure the volume supports the move. In other words, for a contrary example, there was a recent SD that didn't pan out to a trend change because of the non-confirmation in volume. By looking back at the bottom in March followed by the bottom in May you'll see the SD. Now look at the volume. The volume break in May was much greater than in March. This is an indication that there is more selling to do. Second bottoms, if they are true bottoms, should have less selling on the second go around. Simple theory - most of the sellers got out of the way on the first bottom and the second bottom exhausts the remainder.

So, with all that being said, I still haven't answered the question, "What's next?" As stated before, the converging RED trend line and the RED horizontal Floors & Ceilings support should provide some minimal support at 1,060 and over the next few sessions you may see a retest of the 1,080 level. If, once again, we see a light volume retest and accelerating distribution volume, 1,060 will be soon to go. If not, keep a watchful eye on the Stochastic. A crossover here could be something worth taking note of.

I hoped this helped!

Until next time...


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