Tactical Trading Outlook - Daily Outlook #999, 01/05/2005

After two very hard down days the market attempted to stabilize to a degree on Wednesday. Unfortunately, the pattern that has traced out since the Tuesday afternoon low does not inspire confidence that a low is in place. The final thrust lower appears to have begun very late in the day, but at this point it is unlikely complete. We are still looking for a final thrust lower on Thursday at which point a more meaningful recovery should get under way.

The nature and quality of the recovery will tell us a lot. Due to the magnitude of this pullback, there is a growing possibility that we have seen the end of the three peaks and a domed house pattern that I discussed last week. See report #991 December 28, 2004 for a review. That would be the Point 23 peak. If this becomes the case then we will adjust our strategies as needed.

In the mean time, even if a very important high was reached, we are still looking for at least a bounce that should last for several days once the current move is complete. Much of our work points towards the end of the week for a turn higher and the first step in the right direction will come on Friday when the 3-day trends will have a chance to turn up.

Here's Why:

The Dow was down 33 points at its low of the day, up 53 at its high of the day, but closed down 32.95 on its low of the day. Despite the half percent intraday gain the Dow like most indices closed on or very close to their lows of the day. Last night I said I expected the indices to break Tuesday's lows and that happened. I repeated this expectation in the intraday update. However, despite reaching new lows late in the day the pattern does not look like it is finished just yet.

The final leg of the decline may have begun in the last hour of trading. But, even though new lows were reached, the pattern will look better if we see at least a little more downside action. On the S&P 500 the largest level of support is now 1167 to 1173. On the Dow the 10600 to 106400 area held until the very end of the day. If the Dow leaves 10,600 behind then next area of chart support for the Dow is really the 10,460 to 10,500 level.

While I was not surprised to see the pullback early this week, the magnitude of the pullback has been remarkable. The Dow has now closed down for six consecutive trading days and on a 10-day basis the market is oversold. We should be nearing some sort of at least short-term bounce based simply on the oversold condition of the market, but being oversold does not mean it has to bounce.

The strongest reason to look for an end to this swan dive comes from our longer-term cycle turn date, which remains Saturday January 8. Thursday we enter the turn window. A second consecutive Rare Buy signal was given on Wednesday. Remember, this tells us we are seeing an unsustainable selling acceleration and when it ends the market normally bounced in a healthy and meaningful manner.

Now here is where it gets complicated. In the first section I mentioned the Three Peaks and a Domed House pattern. When I introduced the pattern last week I focused on the current analysis on the Dow. However, the pattern is a market phenomena rather than an index specific pattern. What I mean is the pattern forms because of a set of circumstances going on in the market as a whole. It is the circumstances of the market that causes the pattern to surfaces in the Dow, which is highly representative of the whole market.

The third chart is a rush job and a little sloppy, but it gets the point across. I show the Dow and the NASD composite together as these two indices are representative of the market. The main point is that the labeled points line up reasonably well and a solid argument can be made that point 23, the top of the pattern, was reached at the December 23 high.

The real benefit of the three peaks and a domed house is not in predicting the exact high. The real benefit is that if the pattern is in place and point 23 is behind us then we can expect a sharp decline down below point 10. In the case of the Dow point 10 is below 9800 and on the NASD it is below 1800. On the S&P 500 point 10 is below 1060. So, if point 23 has already been reached then we will adjust our trading style to accommodate the expected move lower.

Ok, now for the big question, have we reached point 23? The answer is, I don't know yet. The first really good clue will come on Friday. If the 3-day trends turn back up then maybe we have not reached point 23. If they turn up but the market does not rally very much then maybe point 23 is in place. The other and probably more important suggestion will be the internal character and nature of the next rally attempt, which should get underway in the next day or two. Weak internals on a rally will argue in favor of point 23.

The Dow and NYSE both had a chance to turn their 3-day trends down on Wednesday and they did in fact turn down when they had a chance. This suggests we should see some additional weakness on Thursday. Now the 3-day trends will have a chance to turn up on Friday and the action on Thursday will set the parameters for a 3-day upturn on Friday. The NASD turned its monthly trend down on Wednesday.

Total breadth was -2808 and that is a little better than Tuesday's reading. However, the indices were not down very much considering the negative breadth readings. Total volume was down a little, but it was still a very busy day. Needless to say, breadth was weighted to the downside. The 10-day Advance/decline line fell well below zero for the first time since early October, so at this point the market is now really showing indications of being oversold on more than a very short-term basis.

A second Rare Buy signal was given on Wednesday. With the S&P down 4.31 points today, that gives the first signal a small loss. The trading strategy is to buy the S&P 500, or the SPYders, and hold them for seven trading days. The first signal expires on January 13 and today's signal light goes out on the 14^th. In short, based on the average signal, the S&P 500 should be more than 1% higher by then.

The NYSE 10% up volume indicator did not provide us with a meaningful rally. However, it did stop the decline for a day. So, I will call this signal half a success.

The CBOE delta PCOI (Put/call open interest) ratio has remained above one for seven consecutive days. It fell below one today, but the four day sum has been above five for the past four days. So, the question is, how much downside is there when open put interest is growing faster than open call interest? Expiration is on January 21, as far into the month as it can be. That will probably be longer than the put buyers will want to hold their puts.

This move lower is probably not over just yet, but if we are going to bottom this week then we should reach the low on Thursday. Ideally we will see a negative gap open and run lower in the morning. From there a turn higher, ideally well before the normal 2:30 turn period, will transpire and we will see a healthy recovery and setup for Friday. If we see another up open, I will remain skeptical unless it holds up well through mid-day.

NASD 100 Index (NDX) Trading System, trade the QQQQ:
The QQQQ price equals the NDX divided by 40; however, the QQQQ trades at a discount of about a half a point or 20 points on the NDX.

The NDX fell below 1565 reaching a low of 1562.64. It then rallied up to 1579.31, which is not 1580. Therefore we did not go long the NDX on Wednesday.

We have no position on the NDX.
For Thursday, if the NDX falls below 1555 and later rallies back above 1570 we will go long at 1570 with a stop of 1555. If the NDX opens higher then we will go long on a move back above 1582 with a stop of 1565. At this point it looks like the NDX is going to make a run down towards the 1540-1545 area. Most likely it should break Wednesday's low on Thursday.

The NDX chart is on the Website.

S&P 500 (SPX) Trading System
The SPY price equals the SPX plus about 1 to 3 points, then divide by 10.

The SPX reached a high of 1192.75, but that was before it broke 1185. Its mid-day low was 1185.22 and therefore we did not go long on Wednesday.

We have no position in the SPX.
For Thursday, if the SPX falls below 1182 and later rallies back above 1190 then go long at 1190 with a stop of 1182. If the SPX opens higher, again I recommend skepticism, but we will go long if the SPX pushes above 1196 with a stop of 1188.

The SPX chart is on the Website.

Here's where we are now:

Hop&Pop Stock Portfolio and Flop8&Drop trading:
Click here to see the Hop&Pop portfolio on the Website.
Click here to see the Flop&Drop portfolio on the Website.

It was another difficult day and we were stopped out of another three positions. OHI and AXE, which have done very well for us, were weak on Wednesday and both fell below their stop prices. We managed respectable gains on both positions. PLCM is another story. They just took this one out to the wood shed and shot it. I was unable to find any news to account for the price decline of PLCM on Wednesday or Tuesday for that matter. This is interesting because both the price move was large and volume was very heavy.

3-Peaks & Domed House looking more likely

Here is the Deal:

Here's Why:

Here's where we are now: