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BOTTOM OR CONTINUATION PATTERN? There has been, and continues to be, considerable speculation regarding whether or not the market is forming an important bottom. It is still possible that bottom formation is taking place, but I am beginning to see evidence that maybe it is a continuation pattern instead. A continuation pattern is a consolidation phase that takes place before the market "continues" in the direction it was headed before the consolidation began. In this case the direction is down. The S&P 500 rallied over 26% from the October low to the high that occurred a mere three days later. An initial impulse of that magnitude should have resulted in prices moving higher after a short pull back; however, nearly all that gain was given back within two days and the sideways trading range began to evolve. The trading range is about 20% wide.
Another problem I am seeing on the chart below (and in other medium-term indicators) is that the sideways churning is helping to clear the severe oversold conditions that should have helped fuel prices moving higher. In other words, the implied internal compression of oversold readings is being absorbed by the churning rather than being applied to driving a rally. More bad news, while the indicators are still well below the zero line, the bear market has depressed the overbought side of the range to the extent that the current readings should be considered neutral, not oversold, and, as the indicators approach the zero line, they will be overbought again.
A problem that the 20% trading range has caused is some whipsaw in our mechanical models, so some discretionary analysis and decision making need to be applied. For example, a buy signal was generated for the Financial SPDR (XLF) on November 4. On November 6 it switched back to sell, and a reader asked me how to evaluate the signals in order to avoid the whipsaw. In most cases, reference to the Straight Shots menu would be appropriate. There we have links to a unique set of indicator charts for each of the 25 indexes and sectors we track, so that you can see precisely what the technicals are for that specific index. In the case of XLF we can see on the chart below that one set of short-term indicators derived from that index were very overbought on the day the buy signal was generated. During a bear market, when overbought conditions exist, it is the least favorable time to open long positions.
Bottom Line: The bottom of the market's consolidation range has not been violated yet, so it is still possible that prices may break to the upside; however, if my conclusion that we are seeing a continuation pattern is correct, the technical expectation is that prices will eventually break to the downside. We rely on our mechanical trend models to determine our market posture. Below is a recent snapshot of our primary trend-following timing model status for the major indexes and sectors we track. Note that we have included the nine Rydex Equal Weight ETF versions of the S&P Spider Sectors. This may seem redundant, but the equal weighted indexes most often do not perform the same as their cap-weighted counterparts, and they provide a way to diversify exposure.
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