There is a very well known truth among professional traders – “amateurs control the daily open and the pros control the close”. Looking at the S&P500 equity index this morning at 9:35AM would have given you the impression the new year is off to a very strong start – up almost 12 points (0.57%) in mere minutes. This is when the rookies started to fill out their buy orders at their brokerage companies. However, we were deeply concerned at TRADEPRO Academy when the price stalled at 9:45AM on low volume and the markets began a strong sell-off. From our years of experience trading and teaching, we knew something was fundamentally wrong which could spell trouble for the entire year. After all, when markets start the session strong and close lower, we are seeing the makings of a bearish market.
There are three major signs that the market may be turning down, and we will examine each more closely:
- S&P 500 at 5 Year Resistance Level
- Momentum Divergence
- Russell 2000 Divergence
1. S&P500 at 5 Year Resistance Level
The first and most obvious sign the market is ready for a downturn is the strong trend channel resistance level that has predicted corrections with fierce accuracy since 2010. Looking below, we can see that each time the market has touched the upward sloping resistance level, the price has instantly stalled and lost momentum, sparking a profit locking cycle, which in turn increases the supply, which causes the decrease in overall equity prices. Let’s travel back in time and look at these instances:
- March 23rd 2010 was the first test of the resistance – 9 week market correction triggered, for total loss of 17.13%
- April 29th 2011 was a close second test of the resistance – 14 week market correction triggered, for total loss of 19.56%
- September 19th 2014 was the third test of the resistance – 4 week market correction triggered, for total loss of 9.82%
- January 2015 – could this be a 5 to 10 week drop of 15%?
It is important to note, that we are not perma-bears, in fact we are and will always be more focused on trading opportunities than predicting overall direction. Jesse Livermore once said it is not about being a bear or a bull, it is about being right. However, we know that even in the strongest bull market, there are healthy selling periods and we see one coming to start the new year.
In addition to the next few signs, there is a lot of technical analysis that supports a sell-off to start the year, including Fibonacci confluence, chart patterns, volume analysis and much more.
2. Momentum Divergence
The second sign that the market is ripe for a correction is the massive momentum divergence that is evident on the weekly chart. Let me give you an example of the importance of this occurrence. You take a tennis ball, look skyward and rifle it as far up into the air as you can. Looking at the ball initially, you may be thinking man all that time in the gym is paying off that ball is flying. A couple of seconds later however, you’ll notice that even though the ball is still moving upward, it is doing so at a slower rate. This is the concept of momentum. The markets are soaring to new highs just like the tennis ball, but the momentum is dying out, and without momentum the market has no where to go and must eventually succumb to gravity. Well, get ready folks, gravity is about to flex its muscles.
Look at the chart below and tell me you don’t see the “tennis ball about to fall” sign? When momentum moves lower as prices increase, this is called bearish divergence and a very strong and accurate market reversal pattern.
3. Russell 2000 Index Divergence
Now that you are familiar with the concept of divergence and it’s importance as it relates to momentum, we can talk about the third signal of a market correction. The Russell 2000 Index measures 2,000 small capitalization stocks, which are the young companies that are large enough to trade on the stock market. Essentially, the Russell 2000 is an index full of “growth stocks”, smaller companies with lots of upside. Other indices that are widely quoted in the financial media as the benchmark for market health only capture price movements of large and established “blue-chip” stocks.
So here is the question, what is better for the economic health of a country, all else being equal, increase in prices for growth stocks or blue chips? The answer is growth stocks, because they create more employment opportunities (which is a particularly weak point in the US at this time), and more value overall. Established companies are raking in cash from selling their tried and tested staple products and paying out dividends to share holders. For these reasons, most innovation happens in smaller companies.
We all know that the markets were phenomenal in 2014 based on the major indices, but do you know how the 2,000 small “growth” companies performed in that same time period?
Growth companies did not grow, they spent a year going sideways and returning investors and fund managers nothing more than volatility and sleepless nights. When growth companies aren’t growing this is a bad sign on a broad scale. This divergence does not tell us as much about the timing of a correction, but it does tell us there is certainly a need for one.
On a side note, did you notice the momentum divergence in the index itself?
Only one thing looks certain, 2015 promises to be a more turbulent year, full of wild price swings leading to increased volatility. This may sound like a night mare to you at first, but if you train yourself to spot these repeatable patterns, nothing excites you more than a market that looks like it will move. Where will it go? At the end of the day nobody knows, but I can tell you this much – we will trade in the direction of the movement when the timing is right and return another 70%+ in 2015. That is the beauty of technical analysis and studying charts. You too can take part, sign up today for access to the first 8 lessons of the Trading Foundations course and experience the excitement of trading on the winning side.
“The difference between those that do and those that wish to, is that the former make the decision and take action, while the latter sit and wait for the opportunity as it passes them by.” – George Papazov.
All the best in the new year from all of us at TRADEPRO Academy Inc, we wish you health, happiness and prosperity!