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October 3, 2009

Evidence-Based Trading

Friday's session was about as exciting as watching paint grow (or is it grass dry? I forget), but the week as a whole was quite interesting. Several developments swung odds in favor of our preferred scenario of seeing an interim rally in the dollar. Naturally, there are several points of concern regarding this outlook, so let's dig in for a look at the evidence.

As you can see, the S&P 500 broke a major trend line this week.

s&p 500 daily chart

Even if this decline were not the start of the "big one" which will eventually take equity indexes to new lows, the break of the major trend line suggests we should at least see a significant A-B-C consolidation, retracing a big chunk of the rally. At this point I am assuming the correction will mirror an A-B-C counter-trend rally in the buck. As a side note, those of you using a linear scale won't see a trend line violation. I've found log scale to be much more reliable for trends, but the topic is obviously open for debate. Feel free to chime in.

The weekly SPX chart gives those traders not yet short an excuse to be patient.

s&p 500 weekly chart

As I noted in the comments section Friday, I was eyeing the weekly close for a violation of the 75WMA. It held, so we could simply be looking at a back-test of this level before a run to new highs. However, I wouldn't use this indicator alone as a trigger for trades. It is best used for caution or as a confidence booster should we get a weekly violation. One can also note the weaker volume on the declining weeks.

Fortunately, we have a more acute method for judging the fate of the recent selling. Take a look at the hourly chart:

s&p 500 hourly chart

If the selling is done, we should see an immediate rally to new highs, as price has already traced out a potential A-B-C pattern. On the other hand, if more selling is to come, we should see this first wave complete five minor waves down. Furthermore, the next bounce (minor wave 4) should not overlap minor wave 1, meaning we should see price finish tracing out the 5 minor waves without exceeding SPX 1041 at any time. Given that a divergence has yet to appear on MACD, I give better odds on the 5-wave decline than the A-B-C correction.

We should also keep an eye on the banks:

bank stock index

Despite solid moves to new highs by major indexes in early September, the banks lagged and were unable to overcome an important pivot. Resolving the current boxed zone is an important issue because if the zone fails, we should see the general equity decline accelerate.

As for our star player, the dollar certainly is not going to make it easy to stay committed to the idea of a counter-trend rally. The buck's intraday swings and weak action out of the recent low provide fodder for dollar bears to remain bearish. Of course, the dollar is acting exactly the way it should for the period separating two powerful, impulsive moves: laborious and choppy. One clue supporting the case against a renewed plunge in the buck is the behavior of equities. Once again, they failed to rally when the dollar was down heavily Friday morning. If the buck had much lower prices in store for the immediate future, equities should be anticipating the move with a rally.

Of course, I remain quite bearish on the buck long-term, which is why the Docfolio remains heavily long precious metals. Let's see how their charts are shaping up.

gold chart weekly

Price did not manage reverse the previous week's decline, but any swing traders waiting for such action could be rudely slapped with a $50 or higher breakout before being given the opportunity to get in.

silver chart

After a $5 move out of mid-summer, I could easily imagine price chopping around a bit before the parabolic phase begins.

platinum chart

The candle grouping formed over the last few days has the markings of a mid-point consolidation. If it resolves as such, the pattern projects price to $1200, near-term.

As you can see, there are piles of evidence supporting one case or another. For the moment, I have more confidence in a dollar counter-trend rally than in immediate collapse. The next couple sessions should clarify a few of our points, and we'll go from there.


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