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Technical Analysis of Choppy Markets


Risk roadmap for bulls, bears.

"Nobody spends somebody else's money as carefully as he spends his own. Nobody uses somebody else's resources as carefully as he uses his own. So if you want efficiency and effectiveness, if you want knowledge to be properly utilized, you have to do it through the means of private property."
- Milton Friedman

Everyone is a technician these days and the charts below have been discussed quite frequently. However, technical analysis does provide a helpful road map that can offer context and clarity, both of which are critical in a choppy, sloppy and emotion-filled tape, so let's take a step back and review some basics.

A look at the S&P 500 Index (SPX) suggests extreme caution is warranted here. I've outlined the two-headed monster (a double head and shoulders pattern). Also evident is a base on top of a base and the stochastic divergence back at the peaks. If we take the distance between the top (~1,570) and the neckline (~1,370), the chart implies a break could take us back toward the 1,170 level. That's not to say that's where the market gets to or stops at - it's simply an area of initial support implied by the charts.

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Editor's Note: Professor Collins would like to point out that all charts in this piece reflect closing prices as of Monday, March 10th and thus do not include yesterday's rally.

We cannot ignore the technical damage that has occurred. The markets just broke a major neckline / shorter-term wedge pattern. We have clearly broken the bullish trend off the '03 low.

We are in a short-term oversold condition so perhaps this Fed-inspired, profit-taking, short-covering bounce can carry us back toward 1,350-1,400 but that move would likely be fleeting, judging by the charts. We also have to be careful of short-term oversold conditions in the context of a change of trend. All rules go out the window under that scenario and a tape that is oversold can stay that way or go to a "more oversold" condition. The markets can always stay more liquid than you can.

Looking at a monthly chart on the S&P 500 Index we can also clearly see the double top pattern / horizontal resistance that has been discussed ad nauseam. That probably is as good a reflection as any of the risk / reward dynamic currently. If we continue to see a breakdown in credit, and if that deterioration is just now beginning to accelerate, stocks in all likelihood will head much lower from here regardless of the Fed.

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If you recall Prof. Tuttle did some work back in November analyzing the price action of the equity markets during recessions.

As we noted, since the late 1940's there have been about 10 periods of recession that on average translated into a downturn in the markets of about 10-11 months. Also from that analysis we noted that the average price decline in such periods is roughly 26%.

Coincidentally, a 26% decline off the mid-July peak 1,555 corresponds to move toward this 1,165 area, as you can see below for what its worth. The 1,150-1,175 area would also correspond to a 50% retracement of the bullish move off the 2003 low. At a minimum this analysis suggests more time and price deterioration is likely (particularly if we assume markets will overshoot on the downside just as they did on the upside).

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As I mentioned yesterday, the Dow Jones Industrial Average tested converging upward sloping and horizontal supports at 11,700. We can see the big picture context on a monthly Dow chart.

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We can zoom in on a weekly chart and see the scenario a bit more closely. Taking the top of the head at 14,200 and subtracting the 11,700 neckline suggests a potential price objective of 9,200 on the INDU if/when we break. Shorter term, as I said, it is dangerous for a shorter-term trader utilizing technical analysis to anticipate breaks.

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What does all of this mean? First, risk is high on both sides. Be mindful of the macro environment and the big picture. Swimming against the tide in the context of a change in trend can be disastrous. For five years it paid to buy dips consistently; now it might pay to shift the mindset toward selling into any rallies.

There is always a fear of missing out there. But history tells us that this episode will take some time to unfold. Would you rather be in the markets wishing you weren't or wait for higher probability set-ups?

Rule number one of managing other people's money, as Jeff Saut recently reminded me, is to "do no harm." That is sound advice for this tape. It doesn't mean being paralyzed by fear but it surely doesn't mean attempting to be a hero. Now is not the time for heroes or recklessness as this credit mess is in all likelihood just beginning to escalate.

An improvement in tone of the tape / sustainable bottom would likely occur with more time and a successful test of the cycle lows as we have seen going back through history. Recall a lot of folks thought they were getting into the Nasdaq (NDX) at a good price around 3,000 (a neckline) back in May / June of 2000. We all know how that unfolded. There will be plenty of time to play the upside once we have some further confirmation.

Tradeable bounce as the Fed uses precious bullets or sustainable bottom as the system stabilizes? Strength is an opportunity to sell - until proven otherwise from where I sit.

That's all from the swamp. Be careful and good luck.

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No positions in stocks mentioned.

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