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Today's WrapUp by Martin Goldberg 02.19.2004 Mon Tue Wed Thu Fri Archive |
"Go Ahead, Speculate. But You Should Have a Pocket Full of NASDAQ Puts"
Nasdaq Showing Technical Weakness – The Sequel
Those short of the stock market have been practically run out of town. In spite of valuations and fundamentals, short sellers have been tossed around, beaten, and stomped on for almost a year and a half now. I don’t know any one who even has any short positions at the moment. Even fundamental bears seem almost eager to discuss which sectors and stocks they are buying. American and world business, as measured by the action of the stock market, has never been so universally successful. Consider that there were 655 highs listed in Wednesday’s Investors Business Daily (IBD), and only seven (7) new lows. Looking at the broad market, it seems as if the laws of supply and demand and competition have been repealed forever. Hey Joe Six-Pack. Prosperity baby! Want proof? Look at the stock market. Want more proof? Look at the economic data from the government. They’re confirming each other!
My goal tonight is to take a technical look at the most important stock market index of this era – the Nasdaq from a short (days to weeks), medium (weeks to months), and long-term (years) perspective. This technical analysis shows that the Nasdaq is showing technical weakness. The index sits at a level where there is weakness from all three general time frames, which I will illustrate tonight. In my view, those people tempted and/or compelled by their profession to speculate long in the stock market should go ahead and speculate. But in order to manage risk while providing potential significant reward, I suggest you also carry a pocket full of cheap Nasdaq puts. Here’s why.
Long Term – 2075: An Important but Difficult Road to Cross
It always pays to take a long view of stock market action for an important perspective. Accordingly, a long-term chart of the Nasdaq is shown in the chart below.
As you can see, over the long term, the current Nasdaq level of approximately 2,075 is an important support/resistance level. It also seems to be the level where the Nasdaq went from action that would be somewhat “normal” stock market action to its eventual parabolic run. There were four (4) instances where Nasdaq (approximate) 2,075 was an important level of resistance as shown on the chart. The only time that the 2,075-resistance level was broken decisively was in the fall of 1998, as the Nasdaq entered into an 18-month mania run. Since then the 2,075 resistance level was successfully defended four times including the present. Whether or not the Nasdaq can penetrate 2,075 decisively this time is discussed in the intermediate and short-term analysis, below.
Intermediate Term – Fan Pattern Still Alive
I think that the most important intermediate term trend is the fan pattern formed by the Nasdaq index beginning in March of 2003 to the present. The fan pattern is illustrated in the chart below
Pring states (Page 148) in Technical Analysis Explained, “At the beginning of a new primary bull market, the initial intermediate rally is often explosive, and so the rate of ascent is unsustainably steep. This happens because the advance is often a technical reaction the previous overextended decline, as speculators who were caught short rush to cover their positions. As a result, the steep trendline constructed from the first minor reaction is quickly violated…A new trendline is then constructed, using the bottom of this first intermediate decline. The new line rises at a less rapid rate than the initial one. Finally, the process is repeated, resulting in construction of a third line. These lines are known as fan lines. There is an established principle that once the third trendline has been violated, the end of the bull market is confirmed….”
The “textbook example” of the fan pattern is indicated in the chart above. But rather than sinking just before the New Year as suggested by classical technical analysis, the Nasdaq turned around and went to a new high (thereby resulting in a stop loss hit on my part). Yet, the third fan line is now is acting as an upward sloping line of resistance. So what is going on now? Is the fan pattern not valid? I think that the answer to that question is in the shorter-term chart, which indicates that the Nasdaq entered into an “exhaustion run”. Such exhaustion runs are common occurrences at the end of extended trends, and suggests technical weakness at present. The exhaustion run is discussed in more detail below. I think that if the exhaustion pattern runs its course, the principle of the fan pattern will again show 2,000 as a resistance level based on the (previous) fan lines.
Short Term – Upper Channel Line With Exhaustion Run
The chart below is a 7-month daily chart of the Nasdaq showing the exhaustion run.
The index moved ahead in an upward sloping channel line that began in late August. In early December, it failed to reach the upper channel line before testing (and almost violating) the lower channel line. The Nasdaq appeared to be weak, and ready to crumble technically. However, it then entered into an upward parabolic run and crashed the upper channel line just after the New Year on high volume. All of a sudden the Nasdaq looked like it was heading to the moon! Then it did a textbook 2-bar reversal pattern and sunk to the bottom of the channel line, before rallying on relatively weak volume back to the middle of the channel where it sits now.
In my view, the breaking of the distinct upper channel line is a clear example of an “exhaustion move”. I think that the title of a very good technical article in this Wednesday’s IBD clearly sums up what went on with the Nasdaq recently: “Use Upper Channel To Spot Excess Optimism”. The article focuses on beginning to sell stocks as they break their upper channel line on “excess optimism”.
In addition, note that Pring indicates that breakouts from trendlines such as the one illustrated above that do not hold generally put traders holding the falsely broken out stock in a bad technical position (page 73).
“Often the technical position is worse after such breakouts. This is because breakouts that cannot hold indicate exhaustion, and exhaustion moves are often followed by strong price trends in the opposite direction to that indicated by the (false) breakout.” The Nasdaq may therefore be in a “worse technical position” now than before the false breakout.
More Technical Weakness – Action of Cisco (CSCO)
A clear technical Nasdaq leader of the rally has been Cisco. Again, I’ll reference a “Major Technical Principle” by Pring (page 351). “When several closely related securities are being led by one of the group and that leader fails to confirm a new high, this is usually a sign of exhaustion and is followed by a trend reversal.” I’ll take this opportunity to suggest that Cisco’s stock action is not about routers and switches as much as it is the Nasdaq with a magnifying glass on it. Here’s long-term technical proof of that assertion:
Now let’s put the magnifying glass on the Nasdaq (via Cisco) over a one-year daily chart:
As you can see by the chart above, Cisco was in a well defined upward sloping channel line, which it broke out of after the New Year (in concert with the Nasdaq). Cisco then sank back into the channel, and then below it in a matter of days. Its been 9-days that Cisco has been below its former upward sloping channel. Also observe from the fast stochastic chart, the duration of the oversold condition that has not occurred since the rally began. It appears that if the Nasdaq is going to advance, it will have to do so without the leadership of Cisco. Is that possible? I suppose it is. (I just can’t picture it. Can you?)
More Potential Short Term Weakness – The “Joe Six Pack Factor”
In addition to feeling happy and smart of late, Joe Six Pack makes his investment decisions in mutual funds via his 401K based on TV video and sound bites, and the balance in his quarterly statement. Mutual fund inflows have been very healthy of late (1). The basic reason he owns Nasdaq technology-based mutual funds is primarily, “they’re going up!” With the Nasdaq at about 2,000, at the New Year, he is likely to note that since his last statement, his balance is less and, “they’re not going up any more!” He also remembers that the last time he liquidated in the face of a precipitous Nasdaq drop, it was easy. One phone call did it! If the Nasdaq finishes below 2,000 following March 31st, it could provoke similar selling action on the part of the public.
Summing It Up
As we look at the long term Nasdaq chart again (below for ready reference), there is an obvious trend that has been consistent over the long term. The “trend” is that the Nasdaq either goes UP, or the Nasdaq goes DOWN. It never stays the same. In the aftermath of the largest stock market bubble of at least two generations, I don’t think that trend will change any time soon.
Therefore, in the absence of upward movement, there is likely to be only one other alternative. A rapid drop is likely.
To sum up, if you want to speculate in the broader stock market, go ahead. But you would be well advised to take a pocket full of puts.
Today’s Market
The Nasdaq was down by 30 points (1.5%) today on heavy volume. The Dow and S&P 500 were also down, but only marginally on very high volume. That doesn’t tell the ugliness of today’s stock market action in full because the market opened up like it was going to give us the prototypical flagpole rally that has predominated throughout the mother of all secondary corrections. Closing breadth was very negative. There was happy talk from Applied Materials that made the futures pit happy, followed by good jobs data from the government, all which occurred before the opening bell. The Nasdaq gapped up, and pretty much either traded even or sold off throughout the day. The market closed especially ugly. Even Applied Materials finished in the red. The Nasdaq logged its 4th “distribution day” in 17. Today’s edition of IBD indicated that it there were “three clear higher volume distribution days in 16 days for the Nasdaq. It will be interesting to see if the “hot guru”, IBD, describes today’s action as 4 distribution days in 17, or 3 in 16. In my view the technically based daily paper has almost been cheerleading this rally. An article in today’s IBD had tips on selling, so the hot guru may be changing their view from bullish to bearish. If they do, they will likely take a lot of momentum money with them. Remember, “When you spot a hot guru, it pays to follow his advice.”
The 10-year note finished about even, yielding 4.052%. Here is a chart of the 10-year treasury interest rate, over the short term:
It shows a descending triangle since August. It also shows momentum indicators (below) with lower highs and lower lows. If the support level of about 4% is broken decisively, then technical analysis suggests it could go a lot lower. The dollar was down marginally. Gold was down $3.63 per ounce, and silver was down $0.02.
I’ll sleep well tonight. With my investments, I have a pocket full of puts. I hope you do too!
Have a great evening!
Martin Goldberg
Reference:
(1) “Public Participation 14” Charles Minter, Comstock Partners, Inc. 17 February 2004.
Note:
The upper trendline indicated in the Nasdaq chart, above is confirmed as accurate by similar trends in the Dow and S&P indices and illustrated in a previous Market Wrap-Up article.
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Copyright © 2004 All rights reserved. Martin F. Goldberg, MS, P.E. |
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