STOCK MARKET FOR BEGINNER | Stock & Option Guide

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QQQQ BACKS OFF FROM MAJOR RESISTANCE AT 40 ... I warned that the Power Shares QQQ Trust (QQQQ) would probably run into heavy resistance around the 40 level for at least three reasons. One is that 40 was the low formed in the first quarter of 2008. (Broken support levels become new resistance levels). The second was the down trendline drawn over the 2007/2008 highs. The third reason for resistance near 40 was the fact that it represented a 50% retracement of the entire bear market (and 62% of the drop since spring 2008). And, as was the case with the S&P 500, the QQQQ was in dangerously overbought territory as shown by the daily RSI and MACD lines in Chart 4. The solid line in Chart 4 is the QQQQ/SPX ratio which has been dropping throughout August. That falling line shows that the market has been gradually losing technology leadership since the end of July. That's another short-term negative. Chart support for the QQQQ is likely in the 37-35 region which defines the June/July trading range. A drop to the July low would represent a 38% retracement of the March/August rally. There are other technical reasons to be cautious about the Nasdaq and the rest of the market at current levels.

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BULLISH PERCENT INDEXES ARE TOO HIGH ... Another reason for more caution over the short run is the unusually high readings in Bullish Percent Indexes. [BP readings are based on the percent of stocks in point & figure uptrends]. Readings over 50% were generally associated with signs of a bull market. Readings over 80%, however, usually warn of an over-extended market. Chart 5 shows the Bullish Percent Index for the Nasdaq having reached 90 (which is the highest level in six years). While that may be positive for the longer-term picture, it warns that the short-term trend is dangerously overbought. Chart 6 shows the BPI for the S&P 500 trading over 80 for the first time since early 2007 — another sign of an overbought market in need of some correcting. I showed positive BPI readings for market sectors last week as well. The most overbought are technology (92%), financials (86%), basic materials (85%), and consumer discretionary (83%). Those groups are especially vulnerable to some profit-taking.

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HEALTHCARE ATTRACTS DEFENSIVE MONEY… Another sign that traders are turning more cautious is that stock sectors holding up the best today are defensive groups like healthcare, staples, and utilities. Of those three, only healthcare spent part of the day in the black. Chart 7 shows the HealthCare SPDR (XLV) holding steady today after exceeding its February high. Moving average lines are also positive. The more telling line, however, is the XLV/SPX relative strength ratio below Chart 7. It’s doing just what a defensive group should do. It underperformed during the spring/summer rally (falling ratio) and is starting to show signs of outperformance (rising ratio). That suggests two things. One is that traders are turning more defensive. Another is that the XLV may be a good vehicle for riding out a rise in market volatilty. Another way to do that is to buy volatility itself.

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USING AN ETN TO BUY VOLATILITY … On July 6, I showed an earlier version of Chart 8 which plots weekly bars for the CBOE Volatility (VIX) Index. I wrote that the VIX had a tendency to bottom in July and was starting to find support along its rising three-year support line (second arrow). The Commodity Channel (CCI) Index below Chart 8 shows the VIX to be in very oversold territory. If the market does start to correct from mid-August into September, it would be natural to expect a bounce in the VIX (it’s up 14% today with the SPX down more than 2%). That’s because the VIX rises when stocks fall. One way to buy the VIX is through the iPath S&P 500 VIX Short-term Futures ETN (VXX) which is shown in Chart 9. It’s still in a downtrend, but is starting to bounce a bit. Its rising 14-day RSI (solid line) may be signaling an upturn in VIX volatility. That may be bad for stocks, but it’s good for those who are long volatility over the next month or two.

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DOLLAR DUE FOR RALLY … While stocks and commodities have experienced selling today, the U.S. dollar has rallied. That makes sense since the falling dollar since March has coincided with rallies in both stocks and commodities. Chart 9, however, suggests that an oversold dollar is due for a rebound. The numbers in Chart 10 show a pretty clear five-wave decline in the PowerShares US Dollar Index Bullish ETF (UUP) since March. The latest drop in August, therefore, looks like the fifth and final downwave in that decline. That fifth wave down has been accompanied by a bullish divergence in its 14-day RSI line (see arrow). [Bullish divergences are more important in a fifth wave]. The UUP may reach its July peak in any short-term rally (which could coincide with major stock indexes testing their July low). A rising dollar would also keep downside pressure on commodity markets and stocks tied to those commodities. The dollar may also benefit from its safe haven status when stocks are under pressure. That explains why the Japanese yen is also starting to show new strength against the dollar and the Euro. The longer-term view of stocks remains positive. A number of technical (as well as seasonal factors), however, warn of more turbulence over the next month or two. Hopefully, that will result in a better buying opportunity for stocks in the September/October period. In the meantime, safe havens like the dollar, the yen, Treasury bonds, the VIX, and healthcare stocks should do better. Short-term traders should take some stock and commodity winnings off the table.

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[John Murphy]