Stock indexes follow way of cycles and momentum

Some years ago when the markets and investing were all a great new adventure, a wise old trader suggested the secret to smart trading rested in the card game, Canasta. “Canasta?!!” we said in amazement. “Yep,” he said. “Canasta is a game where mastering the art of the discard can win the game for you.” He went on to explain that a sharp Canasta player can “seed” discards when the stakes are high and a large discard pile is ripe for the taking. In that strategy an opponent can be lead to believe the cards that are being “thrown away” aren’t wanted. But in fact, the sharp player is deceiving the opponent in the hope the other player will then throw away the same cards which the astute player is still holding and which would allow him to “pick up” the discard pile. When the right card is dropped by the opponent, the Canasta strategist swoops in and grabs the big discard pile that is then added to a growing point total.

So it can be with the stock market. Is big money really telling media types when it’s selling? Oh sure. The $100 million player is going to appear on CNBC and tell the world he’s getting rid of his entire gold position. More than likely he will be telling everyone he’s a buyer and maybe even make some obvious purchases to underscore the point. But the core position gets sold. Bigtime. And as privately as possible.

Same goes for buying. When asked, Mr. Big may suggest that XYZ is a “dog with fleas” and will be accumulating a large position on weakness. He might even go a few rounds on the sell side simply to attract more shares from unwary buyers. The point is things in the market are not always what they seem to be. Higher prices do not necessarily a sustainable rally make. Nor do lower prices suggest an unending continuation of the bear.

Which brings to this stock market….

In last week’s Market Summary we suggested that the short-term rally that has been underway since the late August lows (1039.70—S&P 500 and 9936.62—Dow 30) could prove to be the “C” leg of a larger A-B-C countertrend upmove that began after the early July lows. Strength in that “C” leg could ultimately carry the S&P back toward 1158 with the Dow reaching toward 11160. Last week the S&P hit 1157.16 and the Dow tapped 10948.88. So is at least the short-term rally over and could something bigger develop on the downside?

First, we need to point out that the Intermediate Cycle that turned negative at the end of May is now back in positive territory and Momentum is favorable on both the Minor and Intermediate-term Cycles. Problem is, short-term Momentum peaked three weeks ago and hasn’t reached its September 21 levels since then even though prices have moved upward. In addition, Cumulative Volume has yet to better its June highs even though the major indexes are above their June highs.

So we are left with a market that has been rising on weak volume and deteriorating Momentum and has yet to better its April highs where major resistance remains. In addition, index prices are within range of short-term profit targets. There is also a possibility, something we have noted before, that the market could be tracing out a complex Head and Shoulders distribution top with the Left Shoulder at the January 2010 highs, the Head at the April highs, and the Right Shoulder developing in the current environment. Underscoring the unfolding of this potential pattern is deteriorating volume, an historical characteristic of Head and Shoulders tops until the downside breakdown occurs and volume spikes to the upside.

And then we have the behavior of two of our key indicators, the Call/Put Dollar Value Flow Line (CPFL) and the Most Actives Advance/Decline Line (MAAD). Both remain positioned above their February plot lows even though index prices made new short-term lows in that time frame. And both remain modestly below their April highs coincident with the broad market. But neither CPFL nor MAAD have shown any great impetus one way or the other over the past several months to suggest a break from market action to provide us some divergence clues as to probable future price action.

So we must continue tow wait for the market to tell us what it intends. A downside break below the lower boundaries of trailing price channels at 1130 in the S&P this coming week and 10660 in the Dow 30 would likely turn the short-term trend negative and set the market up for some weakness over the next few weeks. What would then become critical is the status of the larger intermediate trend. Weakness below weekly price channels at 1060—S&P 500 and 10100—Dow 30 would set the major indexes up for a “test” of those July lows at 1010.91—S&P and 9614.32—Dow. Selling below those points would almost certainly lead to a severe sell-off with the potential for weakness toward 875 in the S&P and 8740 in the Dow.

Or not. But for the market to put aside all bearish considerations, strength to new highs and movement above the April price highs at 1219.80—S&P and 11258.01—Dow would be an absolute necessity. In the meantime, to help gain some clues into market mysteries a little Canasta might help. But make sure nobody slips in the “Old Maid.”

McCurtain Most Actives Advance/Decline Line (MAAD)

MAAD, based on daily and weekly data, rallied to its best levels last week since April 14 and nearly two weeks before the broad market topped out at the end of April. The indicator is modestly “overbought” on the Intermediate Cycle with plenty of room on the upside on the smaller minor trend.

In a nutshell, MAAD is offering the potential for higher market prices, but as with the major indexes, nothing but new highs will re-assert the uptrend in the indicator begun after the March 2009 lows.

At the same time we must continue to point out that this indicator, which is a reflection of “Big Money,” has yet to recover even 25% of its decline since the October 2007 highs while the major market indexes have recovered nearly 50% of their decline. As a consequence, we must continue to conclude that large players have not been participating in this market, for one reason or another, over the past year and half to the same extent they did prior to the inception of the bear market decline in 2007.

Click charts to enlarge

McCurtain Call/Put Dollar Value Flow Line (CPFL)

Like MAAD, CPFL remains range bound to the extent is has continued to hold above its February support lows and below its April resistance highs. While Call Dollar Volume exceeded Put Dollar Volume every session last week with the ratio of the two favoring Daily Call Dollar Volume by 1.3 to 1, that action was still not good enough to push CPFL on the Daily Cycle above its early August highs as was the case with MAAD last week. Weekly CPFL did make a fractionally higher high above that level, however.

So we are left with yet another indicator that continues to offer upside potential, but has exhibited little enthusiasm over the past several months to achieve that goal. It is also a fact that if the market rallies without CPFL confirmation, the odds of a sustainable rally would not be good.

Click charts to enlarge

Conclusion

After five days of churning the S&P 500 index lost 2.43 points last week while the Dow Jones Industrial Average gave back 30.58 points. At the same time, while the short-term trend remains positive it has begun to exhibit signs of deteriorating Momentum. Cumulative Volume remains weak. Added to the fact that the late April prices highs remain as a major point of resistance and the levels to be surpassed to re-assert the bull trend, longs continue to have a point to prove. Not that they can’t prove that “point,” but the longer it takes to win the argument as to whom will ultimately win out, bulls or bears, the greater the odds the bears will take the field since there are always sellers.

*Note: All data is for week ending on Friday even though ending date may be a holiday.
Unchanged issues in MAAD calculations are not counted.

*Note: Unchanged issues are not counted.

Robert McCurtain is a technical analyst, market timer and private investor based in New York City. If you would like to read more about how the CPFL is constructed, read a Futures article on the concept. This will take you to the MAAD article. Robert can be reached at traderbob@nyc.rr.com.