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Will The Rally Continue? Let's Look At The Technicals

I had a question from a client relative to the technical picture of the market and how we were reading it. I explained that we watch the Oscillators (a momentum indicator) to give us a picture of the short-term direction of the market and to help guide our investment decisions. What we like to look for is that the movement in the Oscillator is confirming the movement in the market itself. If they are moving in tangent, then the current direction of the market (whether it is a rally or a correction) will likely continue. If they stop moving in tangent then we have a negative divergence, or a possible turning point in the direction of the market.

Given that the Oscillator is a bit of a mystery to most people, I thought that it would be a good exercise to demonstrate how it works in action. The discussion in the following paragraphs was adapted from Helene Meisler’s current article on the use of the Oscillator to make it clearer for the readers of this blog.

To demonstrate the use of the Oscillator, let’s look at the Oscillator for Nasdaq, and compare it to the Nasdaq Composite graph above to explain things visually.

Point A is mid-October, when Nasdaq had a high, as did the Oscillator. We then corrected and the Nasdaq went on to a higher high, Point B on both charts, yet the Oscillator went to a lower high. That was a negative divergence in momentum.

Point C in early December is the high following the November correction. We then corrected and rallied again to point D. Note that point D on the Oscillator chart is a lower high. Once again a negative divergence.

Now notice the move the Oscillator has made in the last several days — it’s quite sharp to the upside.

Generally, the window for a rally is open for three to six weeks (from a technical standpoint). The initial two weeks are typically when we see that big rise in the Oscillator like you see from March 9th through yesterday.

We then typically get some sort of pullback or correction, followed by another rally. If that follow-up rally finds the Oscillator (and other indicators we follow) making higher highs, then we know the rally has staying power and enters another three to six week cycle; if it makes a lower high, we start to get cautious on the market and book some profits, place some stop losses, enter some good ‘till cancelled sales with target prices, etc.

The market will likely reach a maximum overbought reading on the Oscillator next week, which conveniently turns out to be just after the end of the quarter and at the beginning of the new quarter. A correction from that point would then set us up for yet another rally in mid- to late April.

It is that follow-up rally where we will be watching for divergences, such as a lower high in the Oscillator, weakening RSI, falling VIX, etc..

For now, though, we haven’t even had the first correction, so the same theme we’ve had for two weeks now is still in place: We continue to have a rally window open and are opportunistically making purchases in high conviction themes (e.g., we added incrementally to our holdings of Monsanto the other day at $95 per share and its now trading at $114).