Drozd: Technical signals warn investors of impending collapse in stock market

On May 6, the Dow Jones Industrial Average (DJIA) suffered a severe 1,000 point drop that sent shockwaves around the world. To this day, investors from far and wide have been trying to understand why. Ludicrous rumours surfaced, one being that someone had accidentally entered an order to sell a billion instead of a million.

I don’t believe there is any single reason or person to blame for the flash crash. I simply believe there were a greater number of “sell” orders offered than there were willing buyers. Prices collapsed because the offers for sale exceeded the pool of buy orders. This in turn triggered sell stops, which drove the market lower. It began a domino effect with selling in one exchange spilling over to the other equity markets.

However, those familiar with technical analysis were not surprised the robust equity markets took a breather. A correction was long overdue as leading technical indicators were in an overbought state for the 10-week period leading up to the flash crash. An overbought market is susceptible to running out of steam and the longer a market remains this way, the greater the ensuing price correction.

On April 26, the price action on the daily charts in several equity markets gave a “sell” signal at the exact height of the 14-month rally. More specifically, an “oops” materialized in the DJIA. This is a reliable technique I learned from veteran trader Larry Williams.

Another sell signal, referred to as a harami on a candlestick chart, developed in both the S+P 500 and the Nasdaq 100. Indicators such as these provide traders and investors with reliable sell signals, especially when they occur at the top of a well entrenched rally.

By week’s end, two-week reversals developed, which gave further verification the equity markets were about to experience additional weakness. More significant is the fact the two-week reversal not only occurred in the DJIA, but it also materialized in the Nasdaq 100. When a sell signal is seen in more than one market in the same sector it takes on greater significance and thus enhances its reliability.

Two-week reversal

A two-week reversal begins to develop when a market advances to a new high and closes at or near the high of the week. The following week, prices open unchanged to slightly higher, but they are not able to sustain follow-through strength. Selling picks up early in the week to halt the advance and prices begin to erode. By week’s end, the market drops to around the preceding week’s low and closes at or near that level.

Market psychology: The two-week reversal is a 180° turn in sentiment. On the first week the longs are comfortable and confident as the market’s strong performance provides encouragement and reinforces the expectation of greater profits. Longs are traders who have bought contracts or shares in anticipation of higher prices.

The second week’s activity is psychologically damaging. It is a complete turnaround from the preceding week and serves to destroy or at least shake the confidence of those who are still long the market. The immediate outlook for prices is abruptly put in question. Longs respond to weakening prices by exiting the market. Some sell to protect profits and others sell to stop losses. This increased selling cause prices to erode.

Unless prices recover by May 31, the DJIA, Nasdaq 100 and the S+P 500 are well on their way to developing a two-month reversal. This will provide additional confirmation the equity markets have run out of steam and will head lower.

Join me online for an audiovisual presentation about this article and chart.

— David Drozd is president and senior market analyst for Winnipeg-based Ag-Chieve Corp. The opinions expressed are those of the writer and are solely intended to assist readers with a better understanding of technical analysis in the markets influencing agriculture. The information contained herein is deemed to be from sources that are reliable, but its accuracy cannot be guaranteed. Visit us online for more grain marketing ideas and educational tools, or call us toll-free at 1-888-274-3138 for a free consultation.

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