Bearish Divergences

By Colin Twiggs
December 2, 2006 5:30 p.m. AET (1:30 p.m. ET)

These extracts from my daily trading diary are for educational purposes and should not be interpreted as investment advice. Full terms and conditions can be found at Terms of Use. The last newsletter for this year will be on Saturday, December 16th. The service will resume on January 9th.

The Big Picture

The Dow is losing upward momentum and several indexes show signs of distribution, while the FTSE 100 and Nikkei display weakness.

January light crude rallied to $63.43/barrel, a long-term bullish sign. The dollar weakened to $1.33 against the euro and appears headed for a test of the early 2005 high of $1.37. Gold rallied to $645 and appears headed for a test of resistance at $675.

Probability of recession in the next four quarters remains at 43 per cent according to the Wright model. A rise above 50% would be cause for concern.

USA: Dow, NASDAQ & SP500

The Dow Industrial Average retraced through initial support at 12200 on Monday, but rallied after testing support at 12100. Thursday's doji candle and increased volume signal resistance, but Friday's hammer after testing support at 12100 shows buying support with a close near the day's high. A rise above Thursday's high [Th] would signal continuation of the short-term rally, while a fall below 12100 would warn of a secondary correction.

Medium Term: The medium-term view appears more ominous. A clear break below the trend channel of the last 5 months (drawn at 2 standard deviations around a linear regression line) signals a loss of momentum and bearish divergence on Twiggs Money Flow (21-day) warns of distribution. A close below 12000 would increase the likelihood of a secondary correction.

Long Term: The Dow is in a primary up-trend, with support at 10700.

The Dow Jones Transportation Average is retracing to test intermediate support at 4600. A fall below this level would signal failure to establish a new high and a test of primary support at 4150. Respect of the 4600 support level, on the other hand, would mean another test of resistance at 5000. Breakout above 5000 would confirm the existence of a bull market.

The Nasdaq Composite is retracing to test the new support level at 2370. If support holds, that will confirm the up-trend -- a positive sign for the broader equity market. Failure would signal trend weakness.

The S&P 500 encountered similar mid-week resistance to the Dow. 

Medium Term: The index is consolidating at the upper border of the trend channel (drawn at 2 standard deviations around a linear regression line), but bearish divergence on Twiggs Money Flow (21-day) warns of distribution. A retracement is likely.

Long Term: The S&P 500 is in a primary up-trend, with support at 1220.

LSE: United Kingdom

The FTSE 100 fell through initial support at 6100 (from the April high) and is now consolidating above 6000. 

Medium Term: Failure of support at 6000 would confirm that the index is undergoing a secondary correction. Twiggs Money Flow (21-day) below zero after a bearish triple divergence warns of strong distribution.

Long Term: The primary up-trend continues, with support at 5500, but the marginal new high (at 6250 compared to 6100 in April) is bearish.

Nikkei: Japan

The Nikkei 225 rallied to test resistance at 16400/16500.

Medium Term: Twiggs Money Flow (21-day) recovered to above zero, but will only turn bullish if the next retracement respects the zero line. Penetration of support at 15500 would warn of a test of primary support at 14200.

Long Term: The index remains in a primary up-trend. Primary support will be weakened if the index fails to test its previous high of 17500.

ASX: Australia

The All Ordinaries is having difficulty overcoming resistance at 5450, with strong volume accompanying the consolidation between 5300 and 5450. Breakout above Friday's high would signal that buyers have prevailed, while a fall below Wednesday's low would indicate that sellers have the upper hand.

Medium Term: A fall below 5300 would signal that the lower border of the trend channel (channel lines drawn at 2 standard deviations around a linear regression line) is likely to be tested, while an upward breakout from the consolidation would indicate a test of the upper channel line. Twiggs Money Flow (21-day) displays a bearish divergence warning of distribution and favoring a downward breakout.

Long Term: The All Ordinaries remains in a primary up-trend with support at 4800.

The object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future.
The actual, private object of the most skilled investment today is 'to beat the gun', as the Americans so well express it,
to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow......
Nor is it necessary that anyone should keep simple faith in the conventional basis of valuation having any genuine long-term validity.
For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs.......

~ John Maynard Keynes

Technical Analysis and Predictions

I believe that Technical Analysis should not be used to make predictions because we never know the outcome of a particular pattern or series of events with 100 per cent certainty. The best that we can hope to achieve is a probability of around 80 per cent for any particular outcome: something unexpected will occur at least one in five times.

My approach is to assign probabilities to each possible outcome. Assigning actual percentages would imply a degree of precision which, most of the time, is unachievable. Terms used are more general: "this is a strong signal"; "this is likely"; "expect this to follow"; "this is less likely to occur"; "this is unlikely"; and so on. Bear in mind that there are times, especially when the market is in equilibrium, when we may face several scenarios with fairly even probabilities.

Analysis is also separated into three time frames: short, medium and long-term. While one time frame may be clear, another could be uncertain. Obviously, we have the greatest chance of success when all three time frames are clear.

The market is a dynamic system. I often compare trading to a military operation, not because of its' oppositional nature, but because of the complexity, the continual uncertainty created by conflicting intelligence and the element of chance that can disrupt even the best made plans. Prepare thoroughly, but allow for the unexpected. The formula is simple: trade when probabilities are in your favor; apply proper risk (money) management; and you will succeed.

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