Don’t Be Fooled Into Making a Costly Mistake

Good news from this side of “the pond” sent stocks sharply higher yesterday. Before the opening it was announced that domestic home building jumped to the highest level in almost two years, and that, along with a successful Spanish debt auction, resulted in an explosive opening. Within minutes, the Dow industrials had gained over 180 points, and that was just the beginning as shorts rushed to cover.

Banks that had been pummeled on Monday mostly erased those losses with JPMorgan (NYSE:JPM) up 5.1% and Bank of America (NYSE:BAC) rising 3.7%. And telecom stocks were active: AT&T (NYSE:T) rose after withdrawing its bid to T-Mobile USA, and Sprint Nextel (NYSE:S) was up 8.3% on the AT&T announcement.

At Tuesday’s close, the Dow Jones Industrial Average was up 2.87%, the S&P 500 gained 2.98%, and the Nasdaq rose 3.19%. Volume fell to typical holiday levels with the NYSE trading 946 million shares and the Nasdaq crossing 532 million. Breadth was positive with advancers ahead by 7-to-1 on the Big Board and almost 5-to-1 on the Nasdaq.

DJI Chart
Click to EnlargeTrade of the Day Chart Key

Just when I thought that the Dow industrials and transports had provided the final bit of evidence that the market was about to break lower, the market turned sharply higher yesterday. Though humbling, reversals on light volume are quite common, especially during a holiday period when volume is light and a few heavy trading firms dominate the exchange floors.

Yesterday’s turn by the Dow industrials surprised me with its violent reversal back up through its 50-day and 200-day moving averages. This was the biggest one-day advance in several months, and it almost turned the MACD slow line to a buy signal (note the arching up of its red line).

DJT Chart
Click to Enlarge

However, before we rush to the buy side, consider that although the Dow Jones Transportation Index closed higher, it failed to punch through its 200-day moving average. Until it closes above the red line we are faced with a non-confirmation of the Dow indices. That non-confirmation may not last long, especially if we get another day up, since the red line of the MACD turned higher yesterday, failing by a fraction to spring a buy signal.

SPX Chart
Click to Enlarge

But before we get too carried away by a one-day holiday trading pop, consider the weekly chart of the S&P 500. The question: Is this the chart of a bear or bull market?

Note the very significant trendline from 1,220 in 2006 to the breakdown in 2008 at 1,298 and its connection to the May 2011 high at 1,370. This line defines the major bear market barrier.

Currently the market is trading within a very narrow range of about 1,125 to 1,275. Day-trading profits can be made on both sides of the market within this range. (For help making fast profits, check out my colleague John Jagerson.)

But thinking that a one-day short-covering rally (yesterday one major firm reported that over 30% of its client holdings had been on the short side) has changed the overall trend could be a costly mistake.

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

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