Wednesday, March 23, 2016

SPX and INDU: Chop Zone Approaching?

One of the biggest errors we can make as traders is to assume that the market will always go up or down.  (What did he just say?)  What I mean is that "sideways" is the Most Frequently Overlooked Option by traders.

Nobody likes a sideways market, because they tend to be difficult to make money in, so we deal with that inconvenience by imagining there will never again be another sideways market.  Unfortunately, we can't make things go away by pretending they don't exist, unless they're already figments of our imagination and never existed in the first place!  The market, of course, isn't a figment of our imaginations -- technically, it's a figment of Ben Bernanke's imagination, which leaves the rest of us powerless to influence it.

Anyway, my point, if I remember correctly, is that after a strongly-trending market, we should be on alert for the market to go into sideways cycling mode.  And along those lines:  While bears tend to fear that market tops occur suddenly and without warning (this is an irrational fear that bears suffer despite all evidence to the contrary), tops are usually preceded by a cycling wave.  So, while the "exact" top sometimes occurs without warning, there is almost always a secondary high that follows after the initial decline.  And that secondary high is, more often than not, the "safer" entry, because it involves less guesswork and provides clearer stop levels.

The chart below illustrates what I'm talking about.  RSI has now reached levels that, in the past, have been associated with sideways markets and/or market tops.  Do note that RSI is not a "pinpoint" indicator, so these cycling/topping moves can begin from modestly higher prices than we're currently at -- but what we do not see on the chart (below) are any moves where RSI reached current levels and the market continued significantly higher without at least a pause/consolidation.

Also note that there is only one instance on the chart below where RSI surpassed 70 and there was an immediate top followed by a steep decline (once in 9 instances).  The reason for this type of action is best understood with the concept of inertia -- a strong rally typically has residual momentum, so it doesn't usually stop on a dime and reverse.  There are usually buyers waiting to buy the first decent dip, so it first slows its residual momentum by chopping sideways, then it reverses its direction and momentum (if it's a top, that is).  Not always -- but usually.

Further contributing to the idea that we may be nearing some sideways movement is the previous price action.  We can see on the SPX chart below that current price levels have repeatedly developed into chop zones for the past year and a half:

In conclusion, RSI suggests we may be nearing a sideways market and/or a topping point, and that it's unlikely the market will continue significantly higher (note this is relative, so even 50 points up from here would not be "significantly higher" relative to the size of the overall wave) without at least a consolidation occurring first.  It also bears mention that -- just going on the odds -- most times that RSI reaches 70, price still has a bit more rallying to do.  Thus keep in mind that my warnings may be a tad premature -- but I always look to see what might be coming before I try to cross The Street.  Trade safe.

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