The Major ETFs in the Week Ahead August 27, 2012

The ETFs: A Positive Sign but Critical Juncture for Stocks!

by Ian Harvey

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August 27, 2012

Introduction

Markets lost ground in the past week, but managed to claw back some of the losses on Friday, August 24.

While the week was still down overall, the index Exchange-Traded Funds (ETFs) remain very close to 52-week highs and two of the Exchange-Traded Funds actually made new 52-week highs this week. That is a positive sign, but as mentioned in prior market summaries, this is a critical juncture for stocks. Declining volume warns the rally may be running out of steam, but price - the ultimate indicator - continues to move higher. Using another indicator, the true strength index, you are able to isolate potential turning points quite early, and keep yourself in the trend if the price continues to rally.

'True Strength Index’ (TSI) is a technical momentum indicator that helps traders determine overbought and oversold conditions of a security by incorporating the short-term purchasing momentum of the market with the lagging benefits of moving averages. Generally a 25-day exponential moving average (EMA) is applied to the difference between two share prices, and then a 13-day EMA is applied to the result, making the indicator more sensitive to prevailing market conditions. After the data is smoothed, some calculations are done to make the indicator fall in a range from +100 to -100, or from +1 to -1.

A signal line (7-day EMA) is usually added - as it is to the moving average convergence divergence indicator - to help identify reversals. In addition, values of -25 and +25, like the levels of 30 and 70 used in the relative strength index, can also be used to identify levels where a security is overbought or oversold. The true strength indicator is a variation of the relative strength index.

The Outlook for the Major ETFs

• The S&P 500 SPDRS (ARCA: SPY), made a new 52-week high this past week at $143.09. That was just above the former high of $142.21. After making the new high, the ETF quickly retreated back toward $140, signaling the break to a new high may be false. It is too early to tell if the move higher was a "fake-out," but the lack of follow-through at such a pivotal level does warrant caution on the long side.

A better short-term indicator, though, is the rising trendline, which started in June. If that trendline is breached to the downside, a top is likely in place. Currently, trendline support is at $136.65. The true strength index (TSI) shows a long-term divergence between the price high in April and the recent high. This is negative for stocks. The TSI is in short-term-rally mode, like price, but TSI has a smoother trajectory. As long as price and the indicator are rising, the best play is to stay long. If the upward trendline in the TSI breaks, it will be an early sign that price is also likely to move lower.


• The Dow Jones Industrial Average SPDR (ARCA: DIA) ETF reached a high of $133.02 this past week, just shy of the $133.14 52-week which occurred back in April. The ETF retreated from the 52-week high toward $130, showing there is resistance in that area. Without confirmation from the Dow, it is highly unlikely the other index ETFs can stage a strong rally.

If the ETF can take another run at the 52-week high in this low-volume environment, and surpass it, the price target is between $136 and $139.

The TSI indicator is showing a long-term bearish divergence, which is negative for the ETF but is not a trade signal in itself. The upward trendline, which started in June, can be used as a trade signal. Trendline support is at $128.25, and if the price respects that line, it is a buying opportunity for another move higher.

If the line is penetrated, it warns a price top is likely already in place. The TSI can be used in the same way. The indicator is an uptrend currently - if that uptrend is broken, the price of the ETF is likely to fall.


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TOP OPTIONS TRADES SINCE JUNE 01, 2012

TRADE GAIN TRADE GAIN
HLF July 47.50 Calls 53% APPL Aug 650 Calls 67%
DLTR Aug 110 Calls 32% UIS Oct 17 Calls 79%
HSY Aug 70 Calls 56% TSO Nov 25 Calls 54%
NKE Oct 92.50 Calls 49% HLF July 47.50 Calls (again) 38%
FB Aug 25.00 Puts 500% DISH Sept 30.00 Calls 100%
APPL Jan 13 650.00 Calls 71% CSTR Oct 42.50 Puts 400%
LNKD Aug 92.50 Puts 30% LNKD Aug 100.00 Calls 250%
SLV Nov 30.00 Calls 114%

PowerShares QQQ ETF (Nasdaq: QQQ), representing the Nasdaq 100 index, was the other ETF that made a fresh 52-week this past week at $68.88, surpassing the former mark of $68.55 from April. While the ETF did pull back after making the high, it held up better than some of the other index ETFs and remains close the new high. If the push higher continues, the price target of $69 to $70 is close at hand.

Volume increased as the new high was made, a positive sign, but is still well below historic volume levels - that's bearish. Trendline support for the current rally is at $63.65.

If the trendline is broken, the price is likely to continue to move lower.

TSI can provide a timelier signal than the price trendline. The indicator is rising, and as long as it continues to rise, the price trend is in no danger. If TSI falls below its own trendline, it warns of a reversal in the price trend.


Russell 2000 iShares Index (ARCA: IWM) ETF, representing the Russell 2000 index, remains well off the 52-week high of $84.66 seen back in March, but did create a multi-month high this past week.

On August 21 the ETF hit an intra-day high of $82.71, the highest price since early May. The movements within the ETF remain choppier than trending, which means breakouts have a higher chance of failing.

$82 was a former resistance level, breached in the past week, but ultimately the ETF fell right back below it. Even if the ETF climbs above $82 again, there is further resistance at $83, $84 and $84.66. Support is at $77.25 and $76.

The TSI can once again be used to verify price movements. If the uptrend in TSI continues, look for the price to begin challenging those resistance levels. If the trendline of the TSI is penetrated, the price action is likely to weaken.


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Conclusion for the ETFs

The ETFs pulled off their highs this past week, with two of the ETFs managing to create 52-week highs. The TSI is useful in trend confirmation, and also for isolating potential reversals in the trend quite early. Unfortunately, no indicator is accurate all of the time.

Currently, the price trend remains higher, and that can't be ignored. But with multiple divergences and sluggish volume, there is cause for caution. Use stops and don't get stuck on only one side of the market. At these important levels, there will either be confirmation that the market is indeed going higher, or the warnings signs will be become reality and the price drop will come.

Other Important Articles Relating to the Week Ahead

1. The Economy and Earnings in the Week Ahead – August 27, 2012

2. The Past Week Stock Market Results – August 27, 2012

3. The Week Ahead in the Stock Market – August 27, 2012

4. Stock Market Monday and Underperformance, August 27, 2012

5. Hedge Fund Managers Becoming More Bullish, August 27, 2012

6. New Range Options from CBOE , August 27, 2012


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