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Monday, October 27th, 2003
Volume 1, Issue #35
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1. THE PRIMARY TREND
The correction that began on Friday, October 17th continued in full force for most of this past trading week. That is, until the last hour of Friday's trading, when we saw a strong rally. Does this rally mark the beginning of a reversal and a return to higher prices?
As I've stated in previous newsletters, the market's recent correction has so far been fairly
moderate. Thus far, no important technical damage has been done. The candlestick this week was a bearish engulfing (see our
"Inside The Black Box" section below for a full description). While the bearish engulfing candle is typically negative, the real body of last week's candle was small, and there was a reasonable-sized lower shadow.
The market's recent correction appears to be normal profit taking and rotation out of stocks that have announced poor earnings and outlooks and into new leaders. My target for a bottom in the S&P remains 1000 to 1010. While the correction is so far going "according to Hoyle," I am monitoring the market closely to make sure it does not develop into something more serious.
On Friday, October 24th, the market declined for most of the day, but rallied back strongly in the last hour. Monday will give a better indication of whether this was merely a case of short-covering ahead of the weekend. Technically, Friday's action can be explained by a successful test of the rising 10-week moving average, which is currently at 1020. The index probed slightly below this level, but then held. The Nasdaq, it is worth noting, tested its first level of important defense at 1850, probed below this level intraday, but closed above it as well, ending the day at 1865.59.
If you've been reading this issue over the past several weeks, then you'll likely remember S&P 1010 on your radio station dial. That level has become extremely important once again. Below the 10-week moving average there is horizontal support at the 1010-1015 level on the S&P. Even more important is the rising trendline off the March 2003 bottom, which as I draw it
intersects the chart at approximately 1010. A break of 1010 on a closing basis would obviously be quite negative.
If the S&P cannot hold 1010 on a closing basis, then the next level of support is the late-September low of 990. The rising 30-week moving average is currently at 977. As long as the S&P holds 960 on a closing basis, the Primary uptrend (bull market) is intact. Higher prices should therefore be ahead.
On the weekly chart, the momentum indictors are providing very little guidance at present. Rate of Change is holding the zero line, but is relatively trendless. MACD continues to flat line, just as it has done over the past several months. Stochastics and CCI are both overbought, but have not yet given sell signals. RSI is in a slight downtrend, but is well above the key 50 level. On Balance Volume has broken out to new highs, confirming the recent high in the S&P.
2. THE INTERMEDIATE TREND
The daily chart also tells the story of a market that's in a correction -- one that rebounded sharply off its rising 50-day moving average. Friday's candle is a large hammer. This often signals a reversal off a bottom. Again, Monday's trading will be important evidence in judging whether the market put in a meaningful low on Friday. The large hammer candle also appears in both the Nasdaq and the Dow Jones Industrial Average charts.
From a positive perspective, Friday's late-day action took the S&P back above rising 20- and 30-day moving averages. However, I am skeptical that Friday's low marked a new bottom because the late-day reversal came with the index a long way from the lower Bollinger band. A penetration of the lower band has marked the end of the last three corrections (in early July, in August, and in late September).
Stochastics, while reaching an oversold level with %K at 29, is somewhat oversold. However, meaningful bottoms are usually found when the indicator penetrates 20. That has not happened yet. CCI has just penetrated the zero line, issuing a sell signal. Meanwhile, MACD is still on a sell signal. The Rate of Change indicator has also bearishly fallen below zero, but is not oversold on its scale. In the last two corrections, the indicator did not bottom until -2.5 on its scale. It is now at -0.47.
Friday's last hour rally was definitely impressive. However, as we will see when we analyze the hourly chart below, all it did was bring the index back to important resistance at approximately the 1030 level. There is still a very strong Minor downtrend line in place.
With the technical picture so mixed, I am cautious about entering new positions. It seems very unlikely that the market will turn around and head immediately higher. Perhaps a trading range will emerge for several days, with support above 1010 and resistance at 1050.
3. THE
SHORT-TERM TREND
On the hourly S&P chart, a small head and shoulders pattern has formed with the head at 1054 and the neckline (or support level) at 1028. When applied to this head and shoulders, the measuring principle indicates that the market could test the 1002 level (1054-1028 = 26 points; 1028-26 = 1002).
The rally in the last hour of Friday's trading brought the index back to the neckline where it should face fairly strong resistance. The rising 200-hour moving average is currently at 1029 -- just a smidgeon above where the index rebounded to. Again, the broken moving average should provide some resistance.
Traders should assess the staying power of this rally should by whether the S&P can again surmount and hold 1030.
If the index can get back above 1030, then there is some resistance at about 1036-1038 as shown on the hourly chart. The upper Bollinger band is also at this level. The trend-following moving average is at 1034 and is pointing sharply downward.
As I draw the down trendline on the hourly chart, it would not be broken until the 1046 level is surpassed. That would require very strong follow-through to Friday's action, and I don't think it will happen quickly.
As the week ends, MACD is well below the zero line and remains on a sell signal. The histogram, however, is rallying and MACD is not far from communicating a buy. Stochastics has rallied up from oversold, as has CCI. RSI has bounced off the 30 level -- the same level that signaled the market's bottom at the end of September.
Again, Monday's action will be important to judge the quality of Friday's last hour rally. While the market may open higher, will it be able to sustain higher prices throughout the day? That should be an important clue as to whether a test of the key 1010 level will be necessary.
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4. TRADING
IMPLICATIONS
The trading action throughout the week of October 20th was bearish until the last hour of trading on Friday. It is difficult to tell yet whether this was merely short covering, or whether it was the start of a meaningful Minor trend reversal.
In terms of our trading ideas, earlier in the week I shorted Ask Jeeves (ASKJ, $19.95). Despite bearish technical signals given at that time, the stock has rallied. I've provided full technical analysis of the position below.
There is still a strong possibility the bottom of this correction will come in the 1000-1010 range. However, before I make any additional trade recommendations, I want to see if the bounce off the 50-day moving average and hammer candle on Friday is a meaningful reversal or just short covering before the weekend. When the technical picture is clearer, I will issue a trade alert via a special News Flash.
5. PICKS OF THE WEEK
STOCK: Ask Jeeves (ASKJ, $19.95)
SOLD ON STOP AT $18.99
LIMIT: $18.90
TARGET PRICE: $16.45
STOP LOSS: $21.30
RETURN: -5.5%
We entered this position via a "sell on stop" order on Thursday, October 23rd. On Wednesday, the stock had closed at $19.27 after a very weak day. My intention was to short on further weakness at Thursday's opening. What happened instead was the stock gapped down, traded as low as $18.58 and then rallied strongly in the first hour. Since that time it has consolidated between approximately $19.25 and $20.40.
The technical picture is more mixed now than when I first recommended the trade. The stock is still below down trending four, nine and 30-day moving averages. MACD and ADX remain on sell signals and stochastics is dropping. On the positive side, the stock has rebounded off its low. A gap created in early October just above $18 has so far held. RSI, after dropping below 50, has rebounded almost to that level. OBV has come back above its own moving average.
What looked like a negative technical picture on Wednesday quickly turned into a mixed one by the close of trading on Friday. I have set our stop loss at $21.35, where the downtrend line will break formed by connecting the mid-September and mid-August peaks in the stock.
6. UPDATE
ON PREVIOUS TRADES
Stock: Nextel Communications (NXTL, $22.09)
Position: Long
Entry Price: $20.85
Target: $23.50
Stop Loss: $22.59 (Revised)
Return: +8.0%
In our Mid-Week Update on October 22nd I revised our trailing stop on Nextel to $22.59. The stock gapped down the next day and opened at $22.42, which became our exit price. The position gained a solid +8% for us.
Longer term, the Intermediate uptrend line off the August 6th bottom remains intact. This trendline is now at about $21. On an Intermediate basis, Nextel remains very attractive.
THIS POSITION IS NOW CLOSED.
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Stock: Georgia Pacific (GP, $26.00)
Position: Long
Entry Price: $26.17
Target: $28.95
Stop Loss: $25.39
Return: 0%
GP has so far withstood the overall market correction very well. It is, however, losing bullish momentum. I am revising my stop loss to immediately below hourly support at $25.49.
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Stock: Protein Design Labs (PDLI, $13.85)
Position: Long
Entry Price: $15.11
Target: $17.95
Stop Loss: $13.49
Return: -10.7%
PDLI had a false breakout over $15.11, which put us into the position. On Monday, October 20th, the stock opened sharply down, taking out our stop loss. Within the hour, the shares rebounded to over $14. The Biotech sector as a whole benefited from a number of analyst upgrades on Tuesday. PDLI is consolidating below $14.50, a previous support level.
THIS POSITION IS NOW CLOSED.
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Stock: Amylin Pharmaceuticals (AMLN, $27.28)
Position: Short
Entry Price: $26.79
Target: $24.25
Stop Loss: $29.20
Return: -1.8%
We entered ALMN via a "sell on stop" order on Monday, October 20th. The stock fell very rapidly after that point, hitting a low below $26. On Tuesday, analysts issued a the bullish call on the Biotech sector, and AMLN subsequently rebounded to near $28.00. Thursday saw a slightly lower low below $26 and then another rebound. The shares traded in a narrow range on Friday. I am keeping our stop loss steady at $29.20.
------------------
Stock: Level Three Communications (LVLT, $5.08)
Position: Long
Entry Price: $5.81
Target: $6.95
Stop Loss: $5.17
Return: -11.0%
We entered a long position in Level Three just as the market turned weak in mid-October. The stock declined steadily, hitting our stop loss on Wednesday, October 22nd. LVLT traded below $5 on Friday before rebounding along with the overall market.
THIS POSITION IS NOW CLOSED.
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7. STOCKS
TO WATCH IN THE COMING WEEK
Long candidates:
AVOCENT (AVCT, $35.92) -- Avocent has broken out of a multi-month consolidation pattern on strong weekly volume. It held up very well during this past week while the overall market experienced strong selling pressure. The stock should find support in the $33-$34 range. When the overall market's Minor downtrend ends, I expect this stock to test $40.
INTERNATIONAL GAME TECHNOLOGY (IGT, $31.12) -- IGT has formed a bullish flag formation. The stock has broken the downtrend line of the pennant and appears to be under accumulation. Again, this is one that should move higher in a strong market.
ACCREDO HEALTH (ACDO, $30.59) -- Accredo is a rapidly growing supplier of mail-order prescriptions. The stock broke out on Friday above a two-month resistance area on volume that was about 25% higher than normal. Additional resistance on the weekly chart can be found near $31, where there was a gap in January 2003. If the stock begins to fill that gap, then it should encounter very little resistance until $35.
TEXAS INSTRUMENTS (TXN, $27.45) -- TXN announced strong earning results on Tuesday and gapped higher, testing $28. It then ran into a very weak market, however, and could not sustain its advance. The shares closed reasonably near Tuesday's high at $27.45. Again, this stock has largely resisted the overall market sell off and should advance when the Minor downtrend ends, if not before.
Disclosure: I hold a position in this stock.
Short Candidates:
TERADYNE (TER, $18.60) -- Teradyne is in a descending triangle and closed very near support at just over $18. ADX has given a sell signal, as has MACD. The shares are below key moving averages. A breakdown here could mean a test of the early-August lows near $15.
GARMIN (GRMN, $42.05) -- Garmin is a manufacturer of global positioning devices. The shares are clinging to support in the $40-42 range. The stock closed almost precisely on its 150-day moving average. A penetration of $40 should see a retest of $36.
8. INSIDE THE BLACK BOX:
TECHNICAL ANALYSIS MADE CLEAR AND SIMPLE
USING BULLISH AND BEARISH ENGULFING CANDLES TO SPOT
TREND CHANGES BEFORE THEY TAKE PLACE
Last week we explored the first -- and perhaps most important -- of the reversal candlesticks, the doji. In doing so, we covered the four primary kinds of dojis: common, long-legged, gravestone and dragonfly. The ability to recognize these candles, I argued, is vital to picking up on trend reversals.
If the doji wins the race as the most important candle to recognize, then the "engulfing" candle comes in a close second. Whereas the doji is a single candle pattern, the engulfing consists of two candles.
An engulfing candle often warns of the approaching reversal of a Minor, or short-term, trend. As you may remember, the Minor trend typically lasts between three and 15 days. As the Minor movement approaches 15 days, I think of it as getting "long in the tooth," and therefore having a significant chance of reversing. When an engulfing candle appears around this time, it often signals the beginning of a reversal.
The engulfing candle must completely "consume" the real body of the previous candle. Because stocks have fewer gaps than commodities, an engulfing candle may violate this rule very slightly by being just above or below the top or bottom of the previous candle. In most cases, you should interpret this as an engulfing pattern.
A bullish engulfing candle occurs after a significant downtrend. Note that the engulfing candle must encompass the real body of the previous candle, but need not surround the shadows. Below you will find an illustration of a bullish engulfing candle:
A bearish engulfing candle occurs after a significant uptrend. Again, the shadows need not be surrounded. Below you will find an illustration of a bearish engulfing candle:
The power of the engulfing candle is increased by two factors -- the size of the candle and the volume on the day it occurs. The bigger the engulfing candle, the more significant it is likely to be. A large bullish engulfing candle says the bulls have seized control of the market after a downtrend. Meanwhile, a large bearish engulfing says the bears have taken command after an uptrend. Also, if volume is above normal on the day when the signal is given, this increases the power of the message.
Candles belong to the category of leading, rather than lagging, indicators. For example, a moving average is a lagging indicator -- it shows trend change
after it has already taken place. By contrast, a candlestick pattern leads the market. It warns in advance that a reversal may be happening.
When that warning is subsequently confirmed by moving averages, it often provides a powerful trading signal.
Below you will find a recent daily chart of the S&P 500 updated through Thursday, October 23rd. In early October note the appearance of a bullish engulfing candle. At this time prices had gone outside the Bollinger band, indicating the market was oversold. The oversold condition was confirmed by stochastics, which were below 20.
The reversal day took place on October 1st (I've labeled this as point #1 on the chart). The previous minor downtrend started on September 19th and was eight days old. (In Primary uptrends, such as the one the market is in now, Minor downtrends tend to be relatively short.) The bullish engulfing candle that then took place was absolutely huge. The volume bar was slightly above the exponential moving average, indicating that the potential reversal had power.
Note that on the next day, moving averages confirmed a Minor trend reversal signal when the four-day moving average penetrated up through the nine. On this day, the ADX indicator gave a buy signal, as +DI crossed above –DI and MACD gave a buy signal as well.
The Minor uptrend lasted twelve trading days before being reversed by a bearish engulfing candle on Friday, October 17th (I've labeled this as point "2" on the chart). Volume on that day was relatively tame. While price closed below the four- and nine-day moving averages, the averages themselves did not negatively cross over until Tuesday, October 21st.
Note that the trend-following ADX and MACD did not issue a sell signal until Wednesday, October 22nd. On Wednesday, what may be called an "engulfing-like" candle appeared. Note how it reversed the two rally days of Monday and Tuesday and brought the index down to the 20 and 30-day moving average lines. The strong volume on this day gave it additional significance.
Bullish and bearish engulfing candles warn of trend change before it happens. Combine the appearance of these candles with moving averages and other trend-following tools such as ADX and MACD, and you should quickly pick up on Minor trend changes. The ability to spot the Minor trend change is key to positioning yourself on the right side of the market, and this, of course, is vital for swing trading success.
Thank you for reading today's issue, and good trading in the week ahead!
Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader
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