Technical Signals A Warning To Investors

David drozd

On Thursd a y, May 6, 2010 the Dow Jones Industrial Average (DJIA) suffered a severe 1,000-point drop that sent shock waves around the world. To this day, investors from far and wide have been trying to understand why. Ludicrous rumours surfaced – one being that someone had accidently entered an order to sell a billion instead of a million.

I don’t believe there is any single reason or person to blame for the flash crash. I simply believe there were a greater number of sell orders offered than there were willing buyers. Prices collapsed because the offers for sale exceeded the pool of buy orders. This in turn triggered sell stops, which drove the market lower. It began a domino effect, with selling in one exchange spilling over to the other equity markets.

However, those familiar with technical analysis were not surprised the robust equity markets took a breather. A correction was long overdue as leading technical indicators were in an overbought state for the 10-week period leading up to the flash crash. An overbought market is susceptible to running out of steam and the longer a market remains this way, the greater the ensuing price correction.

On April 26, 2010 the price action on the daily charts in several equity markets gave a sell signal at the exact height of the 14-month rally. More specifically, an oops materialized in the DJIA. This is a reliable technique I learned from veteran trader Larry Williams.

Another sell signal referred to as a harami on a candlestick chart developed in both the S&P 500 and the Nasdaq 100. Indicators such as these, provide traders and investors with reliable sell signals, especially when they occur at the top of a well-entrenched rally.

By week’s end, two-week reversals developed, which gave further verification the equity markets were about to experience additional weakness. More significant is the fact the two-week reversal not only occurred in the DJIA, but it also materialized in the Nasdaq 100. When a sell signal is seen in more than one market in the same sector it takes on greater significance and thus enhances its reliability.

TWO-WEEK REVERSAL

A two-week reversal begins to develop when a market advances to a new high and closes at or near the high of the week. The following week prices open unchanged to slightly higher, but they are not able to sustain follow-through strength. Selling picks up early in the week to halt the advance and prices begin to erode. By week’s end, the market drops to around the preceding week’s low and closes at or near that level.

MARKET PSYCHOLOGY

The two-week reversal is a 180-degree turn in sentiment. On the first week the longs are comfortable and confident as the market’s strong performance provides encouragement and reinforces the expectation of greater profits. Longs are traders who have bought contracts or shares in anticipation of higher prices.

The second week’s activity is psychologically damaging. It is a complete turnaround from the preceding week and serves to destroy or at least shake the confidence of those who are still long the market. The immediate outlook for prices is abruptly put in question. Longs respond to weakening prices by exiting the market. Some sell to protect profits and others sell to stop losses. This increased selling causes prices to erode.

Unless prices recover by May 31, the DJIA, Nasdaq 100 and the S&P 500 are well on their way to developing a two-month reversal. This will provide additional confirmation the equity markets have run out of steam and will head lower.

Join me online at www.Ag-Chieve.ca/cooperator/foran audiovisual presentation about this article and chart.

David Drozd is president and senior market analyst for

Winnipeg-based Ag-Chieve Corporation. The opinions

expressed are those of the writer and are solely intended

to assist readers with a better understanding of technical

analysis in the markets influencing agriculture. The

information contained herein is deemed to be from sources that

are reliable, but its accuracy cannot be guaranteed. Visit

us online at www.Ag-Chieve.ca/cooperator/formore

grain-marketing ideas and educational tools, or call us toll free at 1-888-274-3138 for a free consultation.

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