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OVERBOUGHT OVERSOLD


R2K Ripe For A 21-Day EMA Retest

03/19/10 09:02:38 AM
by Donald W. Pendergast, Jr.

Based on current internal strength readings and other technical criteria, the Russell 2000 index appears to be at or very near the start of a corrective move lower.

Security:   .RUT, TF, IWM
Position:   N/A

If you've been following my articles here in TCA, you may be aware of an indicator I created in MetaStock that I refer to as ER, or the EmaRat. All it does is plot a histogram of the difference between the 12- and 50-period exponential moving average (EMA) in any given tradable. When used in conjunction with other technical tools, it does a pretty good job of projecting when a given index, stock, or commodity is likely to reverse back toward key support/resistance levels. Right now, there appear to be several indications that the Russell 2000 (along with the Standard & Poor's 500 and NASDAQ 100) is due for a corrective move to lower levels. So let us take a brief look at the daily graph of the venerable R2K to see how heavily the probabilities of a reversal are weighing on the premier US small-cap stock index (Figure 1).

FIGURE 1: RUT, DAILY. Weakening broad market internals, pronounced negative indicator divergences, and a high ER indicator value all combine to suggest that the most likely move for the R2K is down to at least the 660 area, if not lower.
Graphic provided by: MetaStock.
Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.
 
Since making a decisively bullish reversal on February 5, 2010, the R2K is up about 18% in only six weeks and is beginning to manifest the first convincing signs that this particular upthrust has run its course:

* The NASDAQ Composite internal strength indicator (top of chart) is now in a negative divergence with the R2K. Essentially, this means that the supply of fresh buying power needed to continue this current upswing is slowly drying up.
* The detrend oscillator (bottom of Figure 1) is also manifesting a negative divergence with the index.
* The ER indicator is now approaching levels normally associated with price reversals; see the red oval circling the ER histogram (above the detrend).

Now, of course, a trend in motion must always be given the benefit of the doubt, but when historically accurate signs appear warning that a reversal in the Russell 2000 may be likely, it might pay to lessen your exposure if you are already long the US stock market at this time.

Normally, when a valid ER/detrend combo gives a warning sign, if the market in question does break lower, you can usually expect to see a fairly quick rundown to the 21-day EMA (red moving average on chart). If a more powerful reversal is destined to follow, the 50-day EMA will then become the most likely stopping point while the market decides what it's going to do next. These are not exact targets, but based on many years of tracking thousands of charts, they are very reliable support areas once a reversal is confirmed.

Here are a few trading themes that you may wish to pursue if the Russell 2000 index does decide to head south:

A. Sell out-of-the-money call options on the IWM, TF, or .RUT
B. Buy puts, looking to take profits at the aforementioned EMA support levels
C. Short the index itself, being sure to establish targets and stop-loss points before taking the trade, and
D. Short the weakest stocks in the weakest industry groups, using your own well-tested mechanical or discretionary timing method.

Nobody can call the exact turning points in the stock or commodity markets, but very often a given market will give plenty of advance warning concerning its most likely path of least resistance. We should therefore be thankful that the Russell 2000 index has provided us with this latest heads-up.



Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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