Equity index rally extends but beware the gap

Good day! If you're a bull, Tuesday's session was a nice surprise coming back from the holiday weekend. The index futures spent Sunday evening and most of Monday trading in a narrow range, but broke higher in the evening. This breakout continued strongly into the early-morning hours on Tuesday due to strength overseas that accompanied news that Greece has a chance at restructuring at least some of its debt. It resulted in a strong upside gap into Tuesday's opening bell.

The trouble with the gap itself, however, was that it was so large that it left the market extended even before regular trade began. Most of the daily breakout strategies I'd been watching jumped so far past their entry trigger that they were no longer even viable. The market is often tricky when returning from a three-day weekend, but Tuesday's was even more so for many day traders. The best play of the morning did not come from traditional technical strategies like flags or breakouts, but rather from the gap itself.

For those of you that have been reading my column for years, you know that one of my favorite strategies in the indices comes from days where the market gaps like it did on Tuesday. Extreme gaps in the overall market have a strong tendency to pull into the gap's void throughout the morning with the exception being when the gap triggers a larger daily setup. In that case it can be a narrower session.

Dow Jones Industrial Average

Since Tuesday's gap followed several days of upside already, albeit slow ones, it served as a continuation of an existing trend, which is a great gap to fade. The setup triggered when the five minute low was broken. This tends to happen within the first 30 minutes of the day, such as it did on Tuesday. It set the pace for the morning with strong selling into 11:00 a.m. ET and slower selling into the early afternoon. The shift in momentum mid-day helped the market react well to 15 minute 20 period moving average support (Figures 1 and 2) and the market was able to reclaim its morning losses by the end of the day.

Despite Tuesday's gains, the market still ended May with a loss. The Dow Jones Ind. Average ($DJI) fell 1.9%, while the S&P 500 ($SPX) lost 1.35%, and the Nasdaq ($COMPX) slid 1.33%. Defensive stocks were amongst the strongest performers for the month, while global industrial firms such as Caterpillar (CAT) suffered the largest losses.

Tuesday's economic data remained disappointing despite the market's gains as well. May's reading for consumer confidence fell to 60.8 from 66.0 to a fresh six-month low, while prices for U.S. single-family homes also dropped to new lows on the year. Meanwhile, the Chicago Purchasing Managers Index fell from 67.6 to 56.6 in May.

S&P 500

Although this week is a shortened one, it will continue to be a busy one on the data front.

Wednesday brings the ADP National Employment Index, April's construction spending, the Institute for Supply Management's manufacturing index, and May's auto sales.

Thursday will kick off with last week's initial jobless claims, followed by factory orders for April.

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