Tuning Out the Technical Noise

I made a little money last week but most of the profits came in the first half hour on Monday morning. I spent the rest of the week sitting on my hands, trying to guess how weird the selloff would get before hitting a tradeable low.

Capital preservation is the name of the game as we head into earnings season. This means I'm not looking for cheap stocks ready to go up or expensive ones ready to go down.

When the market speaks with such power and fury, it's best to sit up, take notice and watch our backs.

Readers know I've been leaning to the bear side for several months now. Two weeks ago, I outlined a scenario in which the major indices would bounce into October and then break the August lows.

That turned out to be an accurate map for the price action leading into last Friday's close.

But technical elements are not aligned perfectly in favor of lower prices yet.

In fact, directional noise levels are higher now than in mid-September.

So let's look at the current tells and get a handle on this volatile market.

Let's start with a positive divergence in the Nasdaq 100 Trust (QQQQ - commentary - Cramer's Take). For several months I've been harping on distribution patterns in the exchange-traded funds. That's no longer true, at least up to a point. The QQQQs are now flashing a bullish divergence after price broke its September low last week, while On Balance Volume (OBV) did not.

But don't celebrate just yet because the SPDR Trust (SPY - commentary - Cramer's Take) broke both its September price and indicator lows last week. This is generating a brand-new divergence between the two major index trusts. The bottom line: It looks like confusion and conflict is set to rule the roost this October.

Growth stocks and other third-quarter winners look absolutely horrible after last week's selloff. Admittedly my bullish commentary on biotechs last month has turned into my worst call of the year. This sector has been taken out and shot, with many leaders now grinding through major corrections.

Unfortunately I can't find the light at the end of the tunnel for these stocks. The Biotech HOLDRs Trust (BBH - commentary - Cramer's Take) broke down from a three-month head-and-shoulders topping pattern last week. And group leaders Amgen (AMGN - commentary - Cramer's Take), Genzyme (GENZ - commentary - Cramer's Take) and Genentech (DNA - commentary - Cramer's Take) all show distribution patterns that suggest even lower prices in the weeks ahead.

On the flip side, the Semiconductor HOLDRs Trust (SMH - commentary - Cramer's Take) and Nasdaq Composite completed bull-flag patterns late last week. This predicts much higher prices heading through the fourth quarter. Of course, I wish the pattern was showing up across a spectrum of indices and sectors, but it's not.

The Dow Industrials and S&P 500 indices broke important support last week in declines without the positive symmetry of the bull flag. In particular, the Industrials broke a rising trend line going back to the April low. This sets up April levels as a legitimate target for the selloff.

The S&P 500 index is all noise and no signal right now. It broke August support and the 200-day moving average last week, but not decisively. The selloff stopped at the 100% retracement of the late August rally, issuing a "first failure" signal. This has bearish overtones but not enough to bet the store.

In fact, the index could even stage a rally if interest rate fears start to recede. How could that happen? The answer lies in crude oil prices, which appear to be falling at a rapid pace. We also saw pullbacks in basic material and industrial metal stocks last week, a sign that inflation pressure may ease in coming months.

Finally, let's look at the Market Volatility Index (VIX). This fear gauge broke above three-month resistance at the low of the selloff last Thursday. This is exactly the opposite of what's expected at a market bottom. In most selling climaxes, VIX will rise to resistance and then pull back. That didn't happen this time around.

Ominously, this predicts the selloff is just gathering steam, rather than washed out and over. It also suggests the VIX is headed to 18.50 and a test of its April high. In turn, this spike would resolve the divergences noted today by ripping prices to considerable lower levels at the same angle of attack as last week's somersault.

Indeed, cash is king right now and capital preservation is the best way to play this extremely dangerous market.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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