weekend update: Radars Up, Level 1 (the Double Take)

Now that we have 3 weeks of market action for 2014 to study, there are some things moving under the surface that demand some attention. While I have been flipping through my many charts of interest I am noticing myself having to do a double take with several of the key indicators I follow. We discussed a few specific groups that we will need to watch closely in our year end review posts. The two I give the most credence to are the leading sector of 2013, Consumer Discretionary (XLY), and Treasury Bonds (TLT) due to their inverse relationship to stocks. I said in the review that when the leading sector for last year breaks down it will likely be a leading indicator for a soft patch ahead for the market. I also believe that if Bonds issue a buy signal, that would put the current rally in jeopardy also.

What I have seen over the past couple weeks has gotten my Radar into a Level 1 warning stage which I will call "the Double Take". Going forward, just for fun, we will use 3 primary warning levels for the markets, this will simply give a quick summation to how I feel about stocks going forward.

The first Radar level is "the Double Take". At this level nothing is inherently wrong with the market yet, but some interesting indicators are suggesting change may be brewing. When I'm looking over charts and I have to go, "whoa, wait, what? Did I just see that?". And I have to dig a little deeper than a quick glance.

The second Radar level is "Getting Goosebumps". This level suggests that the concerns addressed in Level 1 are starting to come to pass and the market has likely begun to go through a shift in trend. Basically many leading stocks are failing and defensive groups are breaking out, the charts are literally giving me goosebumps. For some perspective of how a Radar Level 2 would come into play would be on a breakdown of that first support from our year end review. It means that things have started to turn and its time to make adjustments.

The final Radar level is what I would call "Look Out Below". This is a scenario where offensive stocks and sectors are breaking major support and the SP500 is failing its rally from the 2009 bear market lows. The bull market is in serious jeopardy, major portfolio risk is elevated, economic readings are signalling recession warnings, companies EPS are coming in consistently lower than prior years, etc. This would be the signal of a bear market (a multi month/year downtrend for stocks).

All that being said, I had to do some serious "Double Takes" this week when looking at some key indicator charts.

For starters, the SP500 year-long daily chart, while simply consolidating nicely over the past few weeks, on closer inspection has been accelerating rapidly and forming a multi-month rising wedge formation. Typically a rising wedge is a reversal pattern and resolves with a break to the downside. We would need to see a break and close below the swing low at 1,815 for this pattern to trigger.

For some larger perspective on the weekly chart, here is the current pattern (pink wedge) along with the prior, larger wedge from early in the year. You can clearly see from the chart that the prior rising wedge we saw (blue wedge), broke to the upside instead of downward. It certainly can be done that way, but the odds are lower for that outcome. All that being equal, when a rising wedge breaks out to the upside it typically is due to a parabolic move in nature and is largely unsustainable without a correction.

So what we have here is a longer term rising wedge that broke out to the upside. That move has now built an even steeper wedge pattern and therefore a higher likelihood of failure to the downside. It appears that in the near term prices have gotten ahead of themselves by breaking higher from the first wedge; price is "blowing off" a bit here. Nothing is confirmed yet as prices have held the prior lows, so we won't get cute and anticipate anything. But this will be something to watch as we go deeper into 4th quarter earnings in the next few weeks. Put these setups on your radar.

Along with the SP500, Treasury Bonds(TLT) will be the most important chart to watch for an impending trend shift.

This first view is a look back at the 5-year weekly chart. What you should focus on here is the inflection level at $110. This has been the most significant level for Bonds since the QE era. In 2010, $110 acted as a ceiling for the uptrend, it then took a year before the resistance was able to be broken. Once it was broken, volatile trading lead to two tests of the $110 level, but it held as strong support (this follows the primary theory that once broken, resistance becomes support and vice versa). Bonds then saw a huge surge that then marked the top for prices.

Once the downtrend began in full force, price was unable to hold the $110 level a third time and failed as support. In October of last year we saw another test of $110 and it rejected price, once again acting as resistance.

We now find Bonds below that key inflection level which suggests the down trend is still in place. However there is something that needs to be watched very closely. This look here is a zoomed in view of the current downtrend. The last "buy signal" that triggered was in the end of 2012 and ended up failing as a trade. I usually find that a failed buy signal (one that gets stopped out quickly after entry) is a strong indicator that a shift is likely. Its been over a year since the last signal for a long entry, but we are nearing a potential signal very soon should we see any more strength in the next few weeks.

Price seems to be putting in a Double Bottom over the past 6 months and appears to be attempting to breakout of the Relative downtrend vs. the SP500. When Bonds are outperforming stocks, its generally not a good thing for the market. We even saw a lower bar 3 weeks ago that broke the prior lows; that bar looks like a shakeout type move and now price is trying to gain some momentum. The last thing that is notable here is that for the entire down trend the 20 WMA has been declining sharply, however recently it has begun to flatten out indicating a slowing of the previous weakness. In fact this setup is eerily similar to what we have seen with AAPL recently, take a look at that post for how history could rhyme this time.

Consumer Discretionary Relative weakness

To start the year, last year's best performing sector group has been showing Relative weakness. The Relative Strength uptrend from the end of last year has been broken decisively, indicating some hot money is flowing out of the space. Price is still above its uptrend supports and is holding the prior swing low, so we don't need to go panicking just yet. $64 is still a fine stop placement and allows us to book solid gains if we do end up being stopped out.

Another positive is that while the shorter term RS trend has been broken, the long term uptrend off the 2009 lows is still well in place and still indicates a secular bull market for XLY.

 While there are still positive trends for XLY in place, many of the key holdings of the fund have been struggling and are failing their 20 WMA's. This will be one to watch very closely in the near term.

Again these are just things to watch for as we go ahead. There are some signs that a more cautious approach may be needed sooner rather than later. But as always we will wait until price confirms these signals and not act on them in an anticipatory way.

My Radar has been activated and we are in a Level 1 caution level. But there is still work to be done for the Bears if they plan on taking back control of the market over the intermediate term. Continue to watch those support levels in the SP500, keep a close eye on Bonds and also be aware of when previously winning groups begin to underperform.