With Russell 2000, Fibonacci Time Zone Nails Turn

04/28/10 01:38:58 PM

by Donald W. Pendergast, Jr.

Just like the circus, the stock market features a "big top." Here's a look at the next likely stopping places for the Russell 2000 index as this reversal unfolds.

Security: IWM. .RUT, TF
Position: Sell

If you watched the televised three-ring circus on CNBC as Goldman Sachs execs faced the roaring lions of Capitol Hill, you probably wondered what was more disturbing -- the testimony (complete with four-letter words) involved or the heavy-duty drop in all of the major US stock indexes. While at first glance, it might appear that the drop was caused by the Goldman/Congressional showdown, in actuality, the drama was merely the precipitating event that set off a decline that was technically already baked into the market cake. A quick look at the daily chart of IWM will help prove this assertion, and we'll also learn where the Russell 2000/IWM is likely to find support on the way down.

FIGURE 1: IWM, DAILY. In the words of a famed trader, "A bear market will take away in a month what a bull market has taken three months to build." Might this new reversal be the resumption of the secular bear market? Or is this just a blip en route to even higher highs in 2010 and beyond?

Graphic provided by: MetaStock.

The Russell 2000 had a great run for two and a half months, coming out of the February 5th low. Look on the chart and witness the Fibonacci time cycle grid that I've overlaid here in Figure 1. Starting the grid at the February 5th low, note the general progression -- the 13-, 34-, and 55-day Fibonacci time cycles all aligned nicely with the underlying market dynamics that drive this key small-cap market, actually marking the ultimate high of April 26, 2010. This is important, as a weekly cycle high was already projected for this same general time, with a major weekly cycle low due by the end of May 2010. So with both the daily and weekly cycle peaking at the same time, there is a high probability that the decline into the projected weekly low will have plenty of downward force pulling it toward significant support levels.

At the bottom of the chart, also note the confirmed negative money flow divergence (based on the Chaikin money flow index [CMF][34]), which had been warning that a reversal was approaching. Now look at the two moving averages on the chart, the 21- and 50-day exponential moving averages (EMAs) (in red and purple, respectively). These two EMAs will normally act as support/resistance during significant market reversals and/or corrections. In this case, the 21-day EMA coincides with the Fibonacci 23.6% retracement line near $71 (pink shaded area on chart), and that price zone may offer a modest amount of support in the next few sessions. Given the twin cycle highs, however, and the fact that the market has risen so dramatically and quickly, the probabilities are that the 21-day EMA will give way without much of a battle, unleashing a fresh flood of selling pressures that could drive the R2K quickly down toward the 50-day EMA/38.2% Fibonacci retracement level near $68.50 (blue shaded area on chart).

Taken as a whole, this chart paints a convincing picture of a major reversal/correction already under way.

Playing the anticipated decline should be easy enough:

* Short IWM, looking to cover near the first and/or second support levels, preferably entering your short position on a temporary intraday bounce higher.

* Wait for the anticipated breakdown from the first support level, looking to hold on for a quick ride south toward the second support level near $68.50. If you go this route, just place a stop-loss a few ticks above the 21-day EMA and then run a fairly close trailing stop if the IWM/.RUT falls as planned.

* Option-savvy traders might employ put option purchases to run the previously mentioned strategies. Just make sure you buy enough time, at least two months of time premium, if not three months' worth, just in case the decline stalls unexpectedly. This will give you more staying power compared to those who unwisely buy options with very short amounts of time until expiration. Options are wasting assets, so use them with care, especially if you're a buyer of option premium rather than a seller.

* Extremely skilled futures traders might attempt to sell out-of-the-money calls on the Russell emini (TF) contract; in this case, selling short-term premium is the way to go. If you get a nice quick rundown to one of the support points mentioned, cover the position, grab the profits, and run for the hills, sparing yourself from the possibility of a short squeeze.

Fibonacci time cycles and retracements can be wonderful tools, but you must always use them in conjunction with other technical indicators. In this case, numerous cyclical, money flow, and trend indicators strongly suggest that the Russell 2000 still has quite a bit of correction to endure before major support is hit and the market stabilizes once again. The action in the next three to five weeks could be especially profitable for traders who are prepared to seize the right opportunities. Will you be one of them?

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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With Russell 2000, Fibonacci Time Zone Nails Turn

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