Networkers Knocked Out

01/20/05 09:47:48 AM

by David Penn

A negative divergence, a hanging man, and a trend channel breakdown conspire to send the AMEX Networking Index down to two-month lows.

Security: $NWX
Position: N/A

The networking stocks were among the first to signal an end to the 2004 bear market. Although it was only a small positive stochastic divergence that developed in the first half of August, that divergence was signal enough that the networking stocks were ready to head higher. While that divergence would not have provided any information about the extent of the advance, it did help alert traders to get on the right side of this group fairly early on.

Using the AMEX Networking Index ($NWX) as a proxy for the networking stocks in general, note how $NWX has snaked higher through a trend channel. There were trend channel touches at the beginning in mid-August, again in early and late September, then one more time around mid-November. This level of contact makes me fairly confident in the validity of the trend channel.

Figure 1: The break of the lower boundary of the trend channel in mid-January was part of a series of bearish signals that the AMEX Networking Index provided traders and investors. After taking out support at 230, the $NWX might require a positive stochastic divergence to alert traders to the possibility of climbing back on board on the long side.

Graphic provided by: Prophet Financial, Inc.

At least until recently, that is. While it only became apparent recently that the trend channel that had accompanied $NWX on its ride up was in danger of being violated to the downside, the notion that $NWX's general uptrend was in danger was available far earlier.

How so? The first warning was in the negative stochastic divergence that developed between mid-November and early December. This negative divergence with the 7,10 stochastic appeared after the uptrend in $NWX was more than four months long and nearly 30% higher than its mid-August low. Momentum didn't shift toward the negative until December 7, a few days after the $NWX tossed up not one but two bearish hanging man candlesticks. These bearish hanging man candles, appearing at the top of mature trends and displaying a long top tail or shadow and a small real body, was the second warning that the trend in $NWX was likely overextended.

Other warnings? Third on the list is the way $NWX was unable to hold support at the 10-day exponential moving average (EMA). I've written before about the 10-day EMA--about the special affinity that traders like Market Wizard Marty Schwartz had for this kind of short-term moving average. And in $NWX, the 10-day EMA played a key role in demonstrating where support was during the index's ride higher in October and November.

Moving into December, however, the $NWX, which hadn't had two back-to-back closes below the 10-day EMA since mid-October, began closing session after session beneath the 10-day EMA. In the context of $NWX's advance, this development clearly spelled weakness. In the even broader context of the technical factors already mentioned--the negative stochastic divergence and the hanging man candlesticks--this potential for weakness should have been hard to miss.

Yesterday, I was listening to Jack Steinman of the website investedcentral.com talk about why he put moving average crossovers at a lower level of priority in terms of spotting trading opportunities. His argument was that by the time the crossover happens, much of the move has already occurred. Traders can debate that point, but Steinman's take was certainly in evidence in the breakdown in the $NWX in January. By the time the 10-day EMA slipped below the 50-day EMA--nearly a month after many of the previously mentioned technical warnings had manifested themselves--the $NWX had fallen from near 250 to just above 230.

This decline seriously tested the lower boundary of the August 2004-to-present trend channel. What's worse for the networking bulls, the decline showed real downside follow-through. After a few tentative probes beneath the lower boundary--probes that initially didn't seem capable of taking out support at 230--$NWX resumed its decline in earnest, smashing through support at 230 en route to 225.

At this point, near-term support is at 220--the area of the October 2004 consolidation that marked the last time the $NWX fought a battle with its 10-day moving average, and lost.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Networkers Knocked Out

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