Stocks suffered a bearish reversal last week with back-to-back days of sharp declines. In fact, last Wednesday’s 108-point plunge in the Dow Jones Industrials wiped out nearly two-week’s worth of gains in just a single session.
Selling this week picked up right where it left off, leaving investors to wonder if this is the beginning of a long anticipated sell-off in stocks.
|It takes more than luck to make smart buy and sell decisions.|
Determining the market’s next move is certainly no easy task in the best of times, let alone with the tricky crosscurrents investors face today. By examining the trading range of the market and key sectors, however, you’ll gain a valuable perspective about the big-picture trend, which can help you spot the most opportune time to buy or sell.
Let’s take a closer look …
Although markets closed lower last week for the first time this year, let’s keep things in perspective. Stocks have come a long way. After posting the best January performance in sixteen years, the S&P 500 Index is still up 6.6 percent year to date. But was this rally too much too fast?
Aside from being up seven weeks straight to kick off 2013, stocks have also gone more than 500 calendar days without at least a 10 percent correction. So I would say we’re overdue for at least a short-term pull back in prices. Just remember corrections of 5 to 10 percent or so are quite normal and healthy within a stock market uptrend.
Take a look at the one-year trading range chart of the SPDR S&P 500 ETF (SPY) below …
It displays the 30-day moving average of prices (blue dotted line), and the shaded area represents the “normal” trading range, which I define as one-and-a-half standard deviation above and below the 30-day moving average.
In plain English, this means that 90 percent of the time (93.3 percent to be exact) you can expect prices to stay within this shaded range, only occasionally moving above (into overbought territory) or below (oversold).
You can see that SPY gapped higher on January 2 and never looked back. In fact, SPY traded above its “normal” trading range for most of January and into February — leaving it extremely overbought at the recent high.
An overbought reading like this can often precede a correction for the overall market, which has now started. So look for initial support at the lower-end of the trading range, near $147 a share.
Keep in mind that just because markets, ETFs, or individual stocks become overbought like this, it doesn’t always mean you should sell on the spot. After all, markets can stay overbought longer than expected.
But a market or an ETF that is already overbought isn’t a particularly good place to be a buyer, either. Once extended beyond the upper end of the normal trading range, it can be a dangerous place to invest.
Now, let’s take a closer look at a couple of sector ETFs to illustrate this point about finding a more favorable entry point within the trading range.
The Consumer Staples SPDR ETF (XLP) is highly overbought right now, as you can see in the chart below…
Even after the downdraft we’ve seen in recent days, XLP remains over extended to the upside, still near the top of its trading range, and perhaps in danger of a sharp correction ahead.
It makes some sense why this ETF would hold up better than the overall market, because there are many defensive stocks in this sector including: Proctor & Gamble, Coke, and Wal-Mart.
But even these conservative stocks can’t swim against the falling tide of a market correction, and will eventually come under selling pressure.
XLP has been a leading ETF this year, to be sure, and has a lot of things going for it. But you might want to also look at other opportunities I see ahead …
For example, the Technology Sector SPDR ETF (XLK), shown below, has already returned to the low-end of its trading range near $29 per share, and may be finding a measure of support at this level.
Technology stocks have been lagging the market during the recent rally. But as the chart shows, XLK remains in a bullish uptrend and is no longer overbought. Now it’s important that XLK hold support here, at the low end of the trading range.
Then, watch for a rally that carries XLK back above its moving average, which may signal a good entry point to go long.
Bottom line: Keep a watchful eye, not only on the stock market’s underlying trend, but also where prices are within the trading range. This can help you pinpoint favorable buy and sell points for sector ETFs and individual stocks, when the odds of success are stacked in your favor.