This column was originally published on RealMoney on May 15 at 12:56 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
Let's look at technical damage done by last week's selloff and see where trading opportunities might be setting up in the days ahead.
decline spared few corners of the market. Technology, blue chips and basic materials all got ripped apart with equal fervor in the worst selling event so far this year.
It was a shock to many bulls coming on the heels of the much-heralded
breakout to multiyear highs on May 5.
That rally erupted after the April labor report eased inflationary fears. But the sharp move showed absolutely no follow through after its initial burst.
Instead, the major indices dropped into a tight range, encouraging bulls to believe the next leg higher would follow the Fed release. But institutions obviously had other plans.
Many folks chose to ignore the bearish divergence flashed by the
averages following the blue-chips' breakout. Those lagging indices were still trading far below their 2006 highs after the employment-inspired rally. Broad moves rarely follow through to the upside when speculative issues lag the blue-chips.
But short-sellers looking for a larger-scale breakdown here will be sorely disappointed. Last week's decline had reached substantial support levels by Friday's closing bell. This sets up the strong likelihood of a countertrend bounce that will shake out weak-handed sellers. This is especially true with the onset of option-expiration week.
This will be the third month in a row the markets are heading into this period dragging around excess negative sentiment.
In the prior two months, this imbalance triggered a jumpy environment where sellers got punished every time they attempted to take prices lower.
Look for the same thing to happen as the new trading week gets underway.
Most traders agree it's been a very dangerous time to carry overnight positions. Fund-driven shakeouts and reversion-to-the-mean computer programs have created a
environment that fades every attempt to take prices considerably higher or lower. It shouldn't be any different this time around, despite last week's events.
But the next rally could set the stage for big trouble into the summer months. Note how the
Nasdaq 100 Trust
broke a yearlong uptrend line during the selloff. Price then expanded sharply below the breakdown level, confirming the key violation. This pattern sets up a major sell signal on any pullback into the trendline over the next few weeks.
One thing concerns me about this clearly bearish prognosis. It's obvious that armchair technicians and the financial press will notice that completed head-and-shoulders pattern very soon. This is exactly what I
want to see at the start of a major decline.
The huge popularity of this classic pattern ensures that legions of amateur sellers will pile into ill-timed short positions. The absolute best trade when that happens is to shake them out with a vertical squeeze.
So, I expect market groups represented in the Nasdaq averages, including technology, small-caps and speculative issues, to bounce soon and head toward newly defined resistance levels. But don't expect prices to fall quickly off those levels because it will take time to punish ham-handed traders attempting to take advantage of the sell signals.
Basic materials and energy stocks sold off during last week's rout as well. But their sharp decline clearly represents a buying opportunity. However, there's a definite risk in taking back these stocks too early on this pullback. Let's look at the most popular exchange-traded fund for the basic-material group to see why.
Materials Sector SPDR
shows a failed breakout on heavy volume over $34.50. This is a clear distribution event that's usually followed by lower prices. The obvious target for this correction lies at the 50-day moving average near $33. That level could mark the pullback low and starting point for a summer rally that takes out this year's highs.
And what about gold and other precious-metal stocks? Although
StreetTracks Gold Shares
shows very little damage last week, the majority of gold stocks I look at declined sharply in the two-day selling event. Once again, this pullback should set up a great buying opportunity sooner or later.
But the overabundance of public love for these overbought issues makes me bearish in the short-term. Simply stated, the questionable willpower of current owners needs to be tested before these stocks can move higher. This sets up a divergent scenario where precious metals stay in rally mode while the underlying equities keep pulling back.
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At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.
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;
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