Equity markets have been on a tear for the past 18 weeks and speculators have continued to add to their long positions throughout this rally, reaching the extreme threshold several weeks ago. Over the past month, commercials have added to their short positions on every market advance, establishing formidable resistance to further price increases. Nevertheless, there was no confirmed trend change - until now.
Confluence of Reversal Indications
As of the close on Friday October 12, 2012, the S&P 500 index, the Russell 2000 index, and the NASDAQ 100 index all have multiple confirmed trend change signals.
The top panel in Figure 1 below is a weekly candlestick chart of the S&P 500 continuous futures contract. The blue line is a 6-week simple moving average. The green line is my version of Larry Williams's price, open interest, volume (POIV) indicator.
The blue line in the second panel below is one of my custom price-volume indicators. When it crosses the purple moving average line, that signifies a trend reversal. Finally, the blue line in the bottom panel is my custom commitment of traders (COT) indicator. Extreme COT values typically precede market reversals.
The red, upward sloping line in the top panel is a support line, but you will notice that it is not based on price. Instead, the support line connects the lows of the POIV indicator, which is designed to lead the market. As a result, when the weekly POIV indicator breaks its own support line, that should give us advance warning of impending price reversals.
The POIV broke its upward sloping trendline four weeks ago (first red oval in top panel below). That marked the first trend reversal confirmation. The S&P futures finally closed below its 6-week moving average on Friday, adding a second reversal confirmation (second red oval in top panel). My custom price-volume indicator in the second panel also closed below its moving average on Friday, adding the third reversal confirmation (also noted with red oval).
The combination of COT values below the bearish extreme threshold and multiple trend reversal confirmations represent significant warning signs and often lead to pullbacks.
We are seeing the same trend reversal indications in the Russell 2000 index and in the NASDAQ 100 index, which corroborates the case for a significant pullback in the equity markets. Figure 2 below is a weekly chart of the Russell 2000 continuous futures contract. The format is the same as Figure 1 above.
Note that the same trend reversal indications are present in the Russell 2000 chart: the POIV trendline break, the weekly close below the moving average, and the crossover of the price-volume indicator below its moving average. As was the case with the S&P 500 index, the COT for the Russell 2000 index is also beyond the bearish threshold.
The story is similar for the NASDAQ 100 continuous futures contract (Figure 3 below). The POIV trendline break and the close below the moving average did not occur until this week, but the price-volume indicator gave us three weeks warning.
Bullish moves do not continue forever. They will always be followed by reversals and sometimes by extended bear markets. However, bearish reversals are notoriously difficult to forecast. Nevertheless, when COT positions are extreme AND there are multiple trend reversal confirmations, the likelihood of a pullback increases significantly.
As noted above, consistent signals in all of the equity indices add credibility to the reversal argument. Furthermore, most of the "risk-on" futures charts look very similar to the equity indices. Risk-on COT indicators are consistently below the bearish extreme and most of these contracts also have one or more trend reversal confirmations: Silver, Platinum, Gold, British Pound, Heating Oil, Canadian Dollar, Copper, Euro, Australian Dollar, etc.
Speculators have accumulated massive bullish positions in risk-on assets and the prices of many of these contracts have already begun to reverse direction. Conversely, the US Dollar futures contract (the classic "risk-off" asset) is far above its COT bullish extreme and its price closed above its 6-week moving average on Friday.
As is always the case, the information presented here is for educational purposes only and should not be construed as investment advice or specific investment recommendations. Please read the disclaimer and terms thoroughly.
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