SFO Magazine: Beware of False Moves

Here is my story for SFO Magazine this Friday:

SFO Daily: Beware of False Moves

Friday, December 23, 2011
By J.C. Parets

Volume is light and volatility is down on the last trading day before the holiday weekend, but stocks are now up for the fourth day in a row. While some traders I know packed it in for the year, there are still plenty of market participants taking advantage of this year-end rally.

The Dow Jones Transportation Average closed yesterday at the highest levels since August 1. Its fellow Dow Theory component—the Industrial Average, is trading slightly below those August levels. Both of these averages are putting in what appears to be an inverse "head and shoulders" pattern.

The Pattern

Although this is typically seen as a positive omen, false moves are a way of life in this market environment. This particular formation made its left shoulder around Halloween, the head around Thanksgiving, and its right shoulder last week.

Key Levels

The "neckline," as this overhead resistance is commonly referred to, is sitting right around 12250 for the Industrials and 5030 for the Transports. A breakout above this level for more than a day or two should bode well for the market as a whole.

Beware of false moves. A convincing breakout next week going into the New Year can potentially catch the bulls off guard. With volume this low, we want to view a breakout of this significance with some suspicion. Remember the extremely low volume sell-off that took place in the days surrounding Thanksgiving? The following week we came back to a rip-your-face-off rally and never looked back. I’m not saying that a fake-out like that will happen come January 3, but we should be prepared for it.

Negative Correlations

It’s important to cheat a little bit by watching what other asset classes and indexes are doing that are negatively correlated with U.S. Stocks. The U.S. Treasury bond market   is the best example of that.

Speaking of false moves, iShares Barclay 20+Year Treasury Bond ETF (TLT) broke out of its range this Monday only to reverse course and sell-off every day since. It is not a coincidence that the TLT sold off the last four days as stocks rallied. With the fund currently trading just above 118, a break below 116 could accelerate the selloff in bonds and help U.S. stocks breakout to new highs.

The Volatility Index is another one to keep an eye on. Also negatively correlated with stocks, the VIX, or "fear index" as it is commonly referred to, has been decimated going into the end of 2011. A decline in volatility is typical for this time of year and normally helps stocks rally in December. That is precisely what we’ve seen. Unfortunately, the selloff in the VIX has taken it down to where it originally broke out from in late July and early August. This former resistance could turn into support here in the low $20s.

BOTTOM LINE

If the Dow Jones Industrials and Transports are going to break out above this inverse head and shoulders pattern, then Treasuries (TLT) and Volatility (VIX) should continue lower. Even with the constructive action in the stock market, false moves are to be expected. There is still plenty of indecision out there so whenever in doubt, trade smaller.

Source:

SFO daily: Beware of False Moves (SFO Mag)

Tags: $VIX $TLT $DJIA $TRAN $IYT $DIA