Is the Trend Still Your Friend?
By Chris Johnson
The market got a brief scare on Monday, as the major indices took investors on a quick trip to some significant short-term support levels. The selling - spurred by a combination of weak economic data, a weak dollar, and fear of weak Black Friday retail sales – dropped the Nasdaq Composite to its 20-day moving average, while the S&P 500 Index and Dow Jones Industrial Average both traded below their respective 20-day trendlines.
The 20-day is significant because it has traced technical support for the major indices since late July/early August, meaning that prices are buoyed when the indices pull back to these trendlines. The implications for the market are positive for the short term, as the majors have now regained control from the short-term sellers. This show of technical strength should play to the bulls over the next few weeks as it signals that there are still potential sideline buyers who are willing to step into the market when it goes “on sale” as it did on Monday.
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But the “bargain hunters” who have so willingly stepped in to buy the market dips represent a dwindling number of potential participants who continue to look for opportunities to catch a ride on the bullish train. Having an idea of the size of this pool of potential players is key to successfully mining the market for buying and selling opportunities. We do this by measuring how bullish or bearish the investing crowd is at any point in time. The more bullish the crowd, the fewer people on the sidelines willing to step up and buy the market on these dips. A more bearish crowd indicates a larger asset pool available to flow into the market.
Enter a couple of our various sentiment measures…
Investor poll activity has been heating up, as the percentage of bullish respondents to the weekly Investors Intelligence poll has been on the rise. The spread between the bulls and bears in this poll is now hovering at some of its most extreme optimistic readings of the past year, indicating that the bullish crowd is growing to a dangerous level.
Volatility indices such as the CBOE Volatility Index (VIX) have continued declining to extremely low readings, a sign of growing optimism or complacency. Last week, the VIX warned short-term traders that the market had extended too far and that a pullback was very likely to occur. Monday’s pullback obliged this sentiment and caused the VIX and other measures of implied volatility to snap to attention and increase by upwards of 30%. This quick rise in these “fear indices” will help the market to continue its short-term rally, though we should approach further buying opportunities very cautiously once the VIX and its siblings move back to their low readings.
As we move toward the end of the week, investors will focus on the slew of economic data that should help fill in the FOMC/interest rate picture. I have referred to the market over the past six months as a “data-point market,” meaning that the market will trade from economic data point to data point with some volatility as traders continue to react to the smaller picture instead of where the market is headed over the longer term. Expect this activity to continue with additional fuel coming from the short-term support of the technical trendlines mentioned above. Bottom line, the saying “the trend is your friend” remains the appropriate cliché for the time being.
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Defining the "Trend"
By Chris Johnson
The market’s recent rally has been underscored by support at key short-term technical support levels, allowing us to dredge up the market cliché “the trend is your friend.” Given this, it begs the question “when does this friend turn on you?”
Simple monitoring of market activity as these trendlines come into play can help to answer this question and save you from a fake-out. In general, these trendlines are effective due to the market’s willingness to defend them. Watching the buyer’s reaction to a “break” of the 20-day trendline (which is the dominant short-term trendline in the current rally) can be very telling. This week’s break of this key short-term trendline was met with almost immediate buying, indicating that investors are still using these pullbacks as buying opportunities. It is when we begin to see the bid and volume for stocks lighten up on the breaks that we should begin to worry about this friend’s loyalty.
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