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Dissecting the Anatomy of an Index


Getting the big picture from the S&P 500's top three names by market weight.

Professional traders are continually scanning the landscape for clues and indicators as to the next big move in the major averages. No matter your holding period, having the "big picture" in mind will give you a road map for further action.

Tuesday marked a 1.25% selloff in the S&P 500 and had many traders scratching their heads. Just as quick, Wednesday action repaired a big chunk of that selloff. Was this merely the pause that refreshes or an ominous sign of further weakness in equities?

What about the recent strength in the US dollar and troubles in Greece? Will Toyota's (TM) woes and the sinking consumer confidence hamper growth through 2010?

Gaining the proper insight can be a tricky equation, as traders want to find the right balance of diligent homework versus sensory overload. I find that focusing on the charts and the subtle clues that they hold is an excellent place to start any top-down approach to a big-picture thesis. Let me walk you through my thought process as I start any weekend review.

Looking at a weekly chart of the S&P 500, a trader would instantly see that despite the monster bounce we've had off the March lows, we're still in a longer-term down trend.

Drilling a bit deeper, a trader could draw a trendline connecting those swing highs from late 2007 and early 2008 on through the current consolidation.

Next, a lateral trendline encompassing the fourth-quarter 2009 highs could also be put in place.

Together, these trendlines form a wedge area where current prices are now sitting.

Our next line of business will be to pull up the daily chart and see if we can further decipher any subtle clues.

Here's a daily from August 2009 through today. As you can see from the chart, I'm keying in on the outside day that we had on October 21, 2009. The day range was 1080-1101, and we find ourselves muddled right back in that area this week.

I believe this key reversal day is crucial to any intermediate-term trends we have in the S&P, and either will be a launching pad or hammer to the head. Each time the index trades in this range, many past participants are emotionally tied to it, and are looking to game it one way or the other. Notice how for six weeks in late 2009 we were range bound as this key area drew crowds upon crowds of traders. The longer we get stuck (or consolidate) in this area, the stronger the next trend will be.

So where do we go from here? I'm not inclined to give theories or guesses to future events but prefer to look at the action as it transpires, keeping in mind these inflection points and the action that surrounds them. I'm just as comfortable playing this from the short side or the long side, and I drill down even a step further and look at the individual names that make up any index.
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No positions in stocks mentioned.

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