Stock market on a razor’s edge

By Prieur du Plessis, on January 19th, 2011 posted in: Investment, Stocks

The post below is a quest contribution by Alexander Elder, trader and author of many books, including “Trading for a living” and “Come into my trading room”.

The market keeps going up, unstoppable like an Energizer bunny. As you may know, I consider the New High-New Low Index to be one of the best if not the best leading indicator of the stock market. January is a good time to review what this indicator is saying right now.

Whenever I look at a chart, I like to begin at its left edge and trace market developments through time – eventually arriving at the hard right edge where we must make our trading decisions.

Looking at this weekly chart of the S&P500 with a 26-week EMA and weekly NH-NL, we can easily recognize several superb signals:

In 2007 the market broke out to a new high, while NH-NL traced a lower peak. When the market fell back below its breakout line, that breakout was marked as a false breakout. That, plus the NH-NL divergence, gave a strong sell signal.
The 2008 – 2009 stock market bottom is the one for the history books. The powerful bullish divergence, coupled with a false downside breakout gave a screaming buy signal to anyone whose ears were open.
In October 2009 the weekly NH-NL rose above 2,500. It exceeds this level only during bull markets. This crossover called for a bull market of several years’ duration.

Of course, no bull market rises in a straight line. At the right edge of this chart we see a bearish divergence of weekly NH-NL. It shows that the bullish leadership of the current rally is growing weaker – a danger sign. Let us now look at the daily chart …

The daily chart of NH-NL shows several troubling developments:

While the S&P is some 70 points higher today than it was in October 2010, the NH-NL is almost 70% below its October peak.
There is a severe bearish divergence of daily NH-NL, with three lower peaks
Last week saw a sudden expansion of New Lows. Up until now the New Lows remained rather flat, the action was in the New Highs, but now the New Lows are coming to life – a sign of downside leadership.

In summary, the US stock market appears poised on a razor’s edge. While the trend is clearly up, both on weekly and daily charts, the NH-NL is flashing red warning signs. It reminds us that bull markets do not move in straight lines, and this uptrend is ready for a pause.

What is a trader or investor to do? The most important step in this situation is to protect your profits on long positions. Every long position you have requires a hard stop (a real order, not a mental stop). The only exception – those stocks that you plan to hold for a lifetime. More adventurous traders may begin scanning the short side of the market.

Source: Alexander Elder, elder.com, January 18, 2010.

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