Weekend Review 05/25/12

Tao gives birth to one,

One gives birth to two,

Two gives birth to three,

Three gives birth to ten thousand beings. --Tao Te Ching

If there is one unifying force to market structure, it is contraction/expansion. The Tao is an expression of the expansion cycle. A rattle snake that coils then strikes exemplifies the movements of contraction/expansion. Throughout nature this pattern repeats. A cloud releases rain (cloud contracts, rain expands) that in turn can turn to ice (expands) which can then melt (contracts) then turn into steam (expands) and becomes a cloud again.

 

What we can learn from this sequence is that once a cycle begins it has a tendency to carry this momentum forward. Price that slows will continue to do so for some time and price that accelerates will continue to do the same as well. Additionally empirical evidence indicates that these burst of momentum will last from 3 to 5 days and that the directional probability of expansion and momentum burst moves with that of the prevailing trend.   

Three weeks ago there was a narrow range on the weekly chart of the NASDAQ and the hypothesis at the time was to expect an expansion in range and follow through in the direction of the move. The first two events did occur, however there was a lack of follow through as the market paused this week.

NASDAQ Weekly

Scoping in on the daily chart a few more details stand out on this time frame. First, a pivot low has been established as the market paused this week. This will now act as a key inflection point for as long as price holds above this level an assumption can be made that a new range is undergoing formation. Second, this week also saw volume drying up so a pause here with a lack of participants particularly after three down weeks is not unexpected especially when coupled with a holiday weekend. Lastly, the past two sessions have showed range contraction with back to back NR7 days. Sticking with the hypothesis that range expansion occurs after range contraction, on the daily time frame the market is due for a move which can lead to further price erosion if the break is to the down side, or a rally within the larger context of a weekly downtrend if it breaks to the upside.

 

NASDAQ 05/25/12

Currently there is still the issue of Greece and a number of other macro events that are pushing noise into the markets and increasing volatility. Coupled with internal market structure, the psychological tolerance of risk on/risk off can be expressed by the relative strength of sector ETFs to the SP. Taking two data points, the market peak and the first of May, it is clear that the current market is still defense oriented with risk off. Utilities and Consumer Staples have outperformed the general market since March 19 and have barely underperformed over the previous month. Tech, Energy and Financials have underperformed with Telecoms doing the worst on both time frames.

Sector Strength

Further using the XLP and XLY consumer sentiment and optimism/pessimism can be gauged by the performance of discretionary or staples. Looking at the XLP, since the market peak there has been an orderly range forming with price near the highs and a consistent volume pattern.

XLP

Looking at the XLY, the range formed since the market peak has been much more erratic and briefly broke the downside and is now retesting that price point. Additionally the volume pattern has been much more erratic with down days showing spikes and a general increase over the up days.

XLY

General market volatility continues to rise as does the uncertainty with news stories filtering in daily. The consensus ebbs and flows from things being bad to not so bad to tolerable to manageable to meaningless to contained that it's basically a coin flip each say as to which news cycle will be the theme.  The way I see it, these are the times to bunker down and reduce the hiss and look at how the information passed off from the market indicates what type of conditions we are now under: risk on or risk off, and not what the bobble heads are regurgitating from the Lehman/Bears collapse because just as market internals repeat the contraction/expansion cycle, news pundits repeat the head in the sand caterwauling and are clacking their teeth like it's 2008.