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Technical Tuesday - 5 Stocks That Forecast Market Reversals

By Chris Rowe September 18, 2012 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

On many Tuesdays (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the Week:

What is the difference between a "shakeout" and a "trap"?

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Would you like to spot the next market reversal before everyone else does?

One trick I use to do this is to watch the small handful of stock charts that have the biggest influence on a major stock index.

It's one technique I teach in my "Technical Analysis Mastery Program."  In fact, it allowed us to "see" the April 2012 top and play it together.

Here's one way to get a head start on market reversals...

The S&P 500 is a large-cap index with 500 stocks.  Most of the stocks have less than one-tenth of a percent influence on the index.  Please reread the last sentence.

But the top 10 stocks actually have more than a 20% influence on the index, and the top 3 stocks have a 10% influence on the index!

 
I analyze the top stocks pretty intensely.  But today, just to give you the general idea, I'll do a tiny bit of analysis on a few of them, just to get you started.

As you can see, Apple Inc. is the most heavily weighted stock in the S&P 500, with a 4.88% weighting. 

At the October 2007 all time high, Apple was was the 18th biggest stock in the index.  It only represented 1.06% of the S&P 500. 

S&P 500 weightings as of 2007

Microsoft was #4, but today Apple's iPhone business alone does more in revenue than all of Microsoft combined!

Let's look at an Apple chart.

The one thing that stands out the most for me is the RSI, a momentum indicator I've written about in the past.  A negative divergence is when the stock makes higher highs, but the RSI (bottom of the chart) makes lower highs. 

A negative divergence, as seen in the first half of the year (mid chart) followed by a sell signal (red dot, lower) is a major precursor to a bearish reversal. 

Of course it doesn't always forecast a major bearish reversal, but it usually does.  In the first half of the year you see we had a HUGE negative divergence.  The market moved way higher while the RSI made lower highs.  That makes the reversal signal more potent. 

Look to the right side of the chart now and you'll see that we got a very small negative divergence followed by a sell signal (green dot).  But since it's small, it's not screaming to sell, yet.  The stock advanced to a new high.  But it STILL MIGHT BE CLIMBING.  

So, as noted on the chart, if AAPL turns down and makes its CURRENT price the new high, then we will have a bigger negative divergence.  That's because we will have established a new high for the stock when the RSI did not yet make a higher high.  See above. 

This is important because it's the most heavily weighted stock on the S&P 500 and on the NASDAQ composite.  As you can see below, the top 10 stocks in the index of a few thousand stocks have a 37% weighting.  The bottom thousand are practically meaningless and unseen.

Exxon Mobil has the second heaviest weighting in the S&P 500, with a 3.2% weighting.  It's worth taking a look...

First of all, although I marked a negative divergence at the beginning of the year, it has no bearing on what we are seeing today.  I just used it to remind you of what the divergence looks like.  Today, you can see we only have a new high for the RSI.  We don't have to think about even looking for a negative divergence until after a sell off, followed by a new leg up.  

Next, note that the stock broke a major high.  In fact it broke out of a 1.5 year base.  It also created an ascending triangle and, since it broke out, that gives us a price objective of $107.  Why?  The price target is the same distance as the width of the base -- 20 points.  Add that 20 points to the breakout point of $87 and you have $107.  This is a huge bullish event for the stock market. 

Next we'll look at Microsoft, the third most heavily weighted stock in the S&P 500 (1.81%) and the second heaviest weighted stock in the NASDAQ (5.43%).

The stock looks like it's also trying to break out of an ascending triangle, just like Exxon Mobil.  If it does, it's a price objective of $33.50. 

A breakout in Microsoft would add more strength to both major indices. 

Next up is IBM.

As you can see, it's the same thing for IBM, except if it breaks out, it will be breaking out to a new high!

Here, we also don't need to think about negative divergences for a while.  So far we have the RSI making a new high.  We aren't even close to the chance for a negative divergence yet.  Even if we get a sell signal in the RSI, I would be very skeptical about it, and would still be bullish -- especially if IBM moves to a new high.

Finally, let's look at Chevron Corp.  Like Exxon Mobil, you can see it broke out of an ascending triangle.  This stock usually trades just like Exxon.  It also has about 20 points of upside from the breakout point, so that's about $130 - $135.

Again, I marked off one prior negative divergence to show you how it works, but today we only have a HIGHER high in the RSI, confirming the higher high in the stock.  

So what's the conclusion?

Most of the biggest stocks are still showing strength.  You have to keep a close watch on Apple Inc. though.  A reversal here would be very unhealthy for the stock market. 

But Apple isn't everything.  If the dollar continues to sell off, or if conflict in the oil producing countries heats up, it would send oil prices higher along with Exxon and Chevron.  

Today, there isn't a big clear picture that we are looking at a reversal.  But as I said in my April 25th article titled "Here's What Oil is Saying About the Economy" if it were, then this article may not be worth writing, as it would be a bit tardy to the warning.  I'm telling you what to watch today -- BEFORE a reversal is clear -- so you know what to watch.

I hope you enjoyed it.  And if you have been learning from these articles and want to see more, I'd love to hear about it in the comments section below.  

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Answer (to TA question from above the article):

A "shakeout" occurs at the START of a new trend, usually a bull trend (like the first sell signal when a new bull market begins). 

A "trap" is a pattern that breaks out in one direction (often, the same direction as the current major trend) and then reverses and breaks out in the other direction (like a quick BUY signal that occurs in a major bull trend that turns into a sell signal on a short term or intermediate term basis). 

We all get caught in traps, and they are pretty much unavoidable and part of the business.  The key is to know when to cut your losses fast when they happen.

Below is a Point and Figure chart within a (not current) candlestick chart of Apple Computer.  They each show the same exact data, but differently.  Since the typical Point and Figure chart fills boxes based on intraday data, the column of Os (with red circle) moved below the previous column of Os, generating a "Sell Signal".   

For Point and Figure chartists, this was a "TRAP.  The stock was in a mature up trend.  This was not the beginning of a new up trend, so it wasn't a "shakeout". 


This is why it pays to view different types of charts, or to focus on details of what happened.  Those who watched the candlestick charts (or the intraday action showing the difference between the low of the day and the closing price) would have seen that the support level was broken only on an intraday basis.  The closing price is most important.  The fact that it closed above or at the support level after breaking support was a bullish sign.  

But notice the sharp move immediately after that.  Short sellers got caught and had to reverse by buying stock back.  At the same time, the bulls were also buyers and many had already sold, so the short sellers had few traders to buy their short-stock back from to close the position.

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