Context is everything in the financial markets. This technical truism, which I coined many years ago, instructs us to examine past action in order to predict the future. It's an especially powerful concept for prognostication that involves price movements over years or decades. In fact, respect for context in 2008 would have saved millions of retirement accounts from major destruction.
With January upon us, it's a perfect time to look at the monthly index charts in order to gauge the broad market's progress in the last two decades and to make logical predictions about price action in 2011 and beyond. Rather than merely being a broad-brush exercise, this contextual analysis could have major implications on your money management in the new year.
I'm going to skip the
Dow Jones Industrial Average
in this survey for the reasons I
. In fact, our media's obsession with the Dow's price action makes it even harder for timing-conscious investors to "read between the lines" and make actionable financial decisions based on market complexity, rather than on the falsehoods of sound bites and employing a spectator sport mentality.
chart vividly illustrates why public investors have become totally disillusioned with Wall Street and the financial markets since the 2008 crash. Simply stated, the blue-chip index has gone absolutely nowhere in the last two decades and is now trading near the midpoint of a 15-year range between 750 and 1550.
This stalemate would be all well and good if enthusiastic investors at the turn of the millennium had been instructed on the absolute necessity of market timing, but they weren't. In its place, Wall Street bankers promulgated a fairy tale in which the market moved ever upward, to infinity, for which the only logical strategy was to buy and hold into your deep retirement years.
That myth has now been thoroughly debunked; survivors have come to understand that they need to focus on key levels traded in prior years and act accordingly. This contextual point of view advises optimism for the S&P 500 in 2011 due to the rapid rise off the bear-market low, followed by an April correction that began at the 62% Fibonacci retracement of the entire decline (red circle in the chart above).
The flash-crash-fueled downturn ended right at the 38% retracement level (blue circle), giving way to a powerful autumn rally that has now mounted resistance at the 62% level. This opens the door to a bull-market advance that should hit 1380, where the 78% retracement point may trigger yet another downturn. Longer-term, the index should return to the 2007 high and start another selloff cycle.
While the Nasdaq 100 gets the majority of bullish attention these days, its monthly chart is far more bearish than that of the S&P 500, thanks to the 1990s tech bubble and subsequent collapse. So, while the S&P 500 returned to the 2000 high at the end of the mid-decade bull market, the Nasdaq 100 stalled just under the 38% retracement level (red circle) of the massive 2000-to-2002 downtrend.
The two-year recovery has now lifted the index back into the 2007 high, but recent price action shows no test or consolidation. As a result, the odds favor a steep decline off this level, or at least an extended period of sideways movement. This context explains the basis for my negative view on tech stocks in the first half of 2011, outlined in a
The index tested the 50-month moving average over the summer (blue circle), and I expect a 2011 downturn to hold well above that level. However, a selloff that breaks round-number support at 2000 appears probable in the first quarter. A decline through that level, followed by a solid rally back above it, will yield an early signal to reestablish long positions in tech stocks.
Let's close out this contextual analysis with a long-term look at the Russell 2000 Index. I've chosen this instrument over the
because small-cap positioning could be vital to the broad market's progress in the next few years. With that in mind, as you can see on the 20-year chart, the index is running straight into a ceiling of resistance at the 2007 high (red circle).
In fact, the Russell is trading less than 70 points from that level ahead of the first quarter, which is a seasonally positive period in the small-cap universe. However, it looks as though major index gains have been pulled backward into this quarter by overeager funds, and that the instrument likely to underperform in the first half of 2011.
A surge into resistance at 856 might fool investors with an early January rally that feels like a breakout, but is actually an exhaustion event ahead of a persistent decline. I'll then be watching the 50-month moving average, which is currently near 650. That support level could offer a great opportunity to get on board ahead of a small-cap rally that carries the Russell to an all-time high.
At the time of publication, Farley had no positions in the securities mentioned, although holdings can change at any time.
Alan Farley is a private trader and publisher of
Hard Right Edge
, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of
, a premium product from TheStreet.com that outlines his charts and analysis. Farley has also been featured in
. He has written two books:
, due out in April. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
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