The R2K And The EMA

06/09/10 08:42:03 AM

by Donald W. Pendergast, Jr.

Some people are so rich that the gyrations of the financial markets don't mean a thing to them. But for mere mortals possessed of ordinary financial means, whenever a stock or stock index closes below its all- important 200-day EMA, traders and investors are quick to take note of such bearish confirmations.

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

The last time the Russell 2000 (.RUT, TF, IWM), also known as the R2K, made a daily close (496.52) below its 200-day exponential moving average (EMA) was on July 14, 2009. At that time, the index was just starting higher on the second wave up from the historic March 2009 lows. We all know what's happened since last summer, with the R2K gaining an astounding 249.43 points (a more than 50% gain) during the next three calendar quarters, finally topping out at 745.95 on April 26, 2010. Of course, we also are painfully aware of all of the brutal waves of selling that have hammered this key small-cap stock index in the past six weeks, and now that the index has finally closed beneath the widely watched 200-day EMA, what might we expect to see in the way of price action for the summer of 2010? Figure 1, the daily chart, provides several clues, along with a few interesting contradictions.

FIGURE 1: R2K, DAILY. Fairly soon, traders and investors should be able to have a better grasp of the developing bear market's true intentions. For now, a minor bullish bounce would not be surprising, but don't expect it to last very long or be very strong.

Graphic provided by: MetaStock.

Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.

Short term, the R2K is beginning to manifest some signs of bullish divergence, particularly when measured with the WB detrend oscillator (bottom of the chart), and to a less noticeable extent by the NASDAQ Composite internal strength indicator (top of the chart). In addition, if you were tracking the NYSE TRIN closing values over the past two sessions (including today), you'd also be aware that two consecutive high closing TRIN readings (13.14 and 2.07, respectively) suggests that the market as a whole is ready for at least a minor bounce higher within the next couple of sessions. So for what it's worth, that's the good news -- the selloff may be due for at least a temporary breather.

Now for the bad news. If you'll again take a glance at the internal strength indicator, pay special attention to the red arrow that connects the February 2010 low with the most recent low attained by this vital market timing measurement. Now turn your attention to the actual February 2010 low on the price chart itself and compare it to today's closing price. Unlike the other short-term bullish divergences mentioned, this is a hugely bearish divergence between the price action of the R2K and the internal strength of a closely related market, the NASDAQ Composite. Note how much stronger the internal strength readings were in February 2010 than they are today, even though the R2K is still about 38 points higher now that it was at the February 2010 low. If there ever was a warning signal for lower index prices ahead (perhaps substantially below the 580.49 reading of the February 2010 low), then this has got to be it.

Finally, a tentative measurement can be made for potential price targets, using simple ABCD swing analysis. Bear in mind, swing price target calculations work best in markets that are making very large, very pronounced and well-proportioned swings (and this price chart of the R2K is textbook quality in this regard). Using a very simple swing calculation, we can arrive at a contracted price target and a nominal price target, as follows:

Contracted swing CD price target formula:

((B-A) * 0.618) + C) = D
((617.61 - 719.70) * 0.618) + 670.59) = D
((-102.09) * 0.618) + 670.59) = D
(-63.09) + 670.59 = 607.50

Nominal swing CD price target formula:

((B-A) * 1.00) + C) = D
((617.61 - 719.70) *1.00) + 670.59) = D
(-102.09) + 670.59) = D
(-102.09) + 670.59 = 568.50

Plugging in the Fibonacci ratio of 1.618 (instead of 0.618 or 1.00) gives us the expanded swing CD price target (if the market really goes into full bear mode soon):

((B-A) * 1.618) + C) = D
((617.61 - 719.70) * 1.618) + 670.59) = D
((-102.09) * 1.618) + 670.59) = D
(-165.18) + 670.59 = 505.40

Of the three potential target areas, the first one (607.50) is only 10 points beneath the current price. The next target price (568.50) is a full 12 points beneath the February 2010 swing low of 580.49 and appears to be more in tune with the long-term bearish internal strength situation. If a super 2001-02 style bear erupts, however, the target near 505.00 might actually be seen later in 2010 or by early 2011. Bear in mind that these price targets can and should be adjusted as future swings in the R2K play out; just make sure that the swings you base your measurement on are easily identifiable as sizable swings, as you will be rewarded with a much greater degree of price target accuracy than if you just pick minor two- to three-bar swing moves that are of little consequence in the larger scope of major market moves.

Right now, with the market caught between the opposing forces of a short-term oversold dynamic and a longer-term bearish disintegration, it might pay to sit on the sidelines for a few sessions, as the price action for the remainder of this week could be especially treacherous to navigate as these two opposing forces start to wrestle and wrangle. It should be a real hoot to watch.

If the bears win, look out below!

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
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Phone # for sales:	904-239-9564
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The R2K And The EMA

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