So Much for the ‘Draghi Bounce’

by John Lansing | August 1, 2012 8:55 am

The hope among market-watchers was that this past Thursday’s gap-up in the markets would mark a breakout from this narrow trading range we’ve been stuck in for a while. After all, that day’s remarks from ECB chief Mario Draghi[1] were the most promising so far that real relief from the central banks is on the way.

But right away, I saw that many of my “indicators and oscillators” were continuing to flash technical damage to the major indices anyway.

Frankly, I wouldn’t have believed it myself unless I saw it with my own eyes. But you can’t ignore the type of potential signals and “red flags” that I was beginning to see. Let’s take a look — but first, let me explain my terminology.

Indicators are calculations based on the price and volume of the underlying security: a stock, exchange-traded fund, currency, commodity or even an index. In and of themselves, they really only have the ability to do one of two things:

1. Confirm a move that’s already in progress and keep us informed at all times as to the strength of that trend and/or momentum.

2. Give us new signals of a trend change that we might not be able to otherwise see by looking at price action alone.

Some indicators are confined within a predetermined range; these are the “oscillators.” They have a scale (typically found at the right side of every chart) with readings that can be anywhere from 0 to 100. As long as your underlying has daily, weekly or monthly price fluctuation, the oscillator will flow along its scale endlessly — that’s how you’ll see the strength or weakness of the security you’re analyzing.

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In this case, on Friday, I started looking at both the iShares Russell 2000 Index Fund (NYSE:IWM[2]) and the Arps Trend Index. Even with the “Draghi bounce,” the latter oscillator still closed red because the stocks opened up higher than where they ended up closing. That’s why you see this red candle here:

So you can see in the lower chart that the already very negative momentum actually continued to get worse — in fact, the worst of 2012.

If the last couple of uninspiring trading days weren’t enough to make you stop believing in the Draghi bounce, just look at the last time we saw something like this on the screens:

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Back in November, see how the green was below this euro line? It’s not bullish when you’re below this euro line. But when it’s green and below this euro line, it’s telling you that something is going to be bullish soon.

It’s a leading indicator. A lagging indicator would give a signal after the trend has changed and confirms what the price action is already telling you — but a leading indicator gives a signal before the new trend or reversal actually occurs.

So the green under where my arrow is pointing, on Thanksgiving Day, is telling you something’s going to happen. Well, we gapped up that next day — and kept going up and up enough to cause a bullish trend reversal. Then that led to this big, huge rally that pretty much every index saw throughout the end of 2011 and the beginning of 2012, before it all tapped out.

Now, there’s no indicator or oscillator that will ever tell you where the top is going to be. That’s what we learn from interpreting chart patterns and Elliott Wave and other forms of technical analysis. The indicators and oscillators simply tell you the momentum of what you’re seeing. And they’ll often alert you ahead of time to a possible trend change — something you’re not able to see within the price action. In this case, as I said, this was giving a heads-up that something bullish was about to happen. And sure enough, it did.

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Now here, after we topped and everything — all that we’ve done over the past couple weeks has been nothing more than this counter-trend bounce. (You can see it right here where we broke south out of these blue lines.) And even with this counter-trend bounce, our oscillator never went green. It just wasn’t giving the signals that you saw going into the beginning of May when price was falling.

Even since then — all red, going lower and lower. And prices haven’t even hit new lows yet. That’s how scary this is!

So did Draghi’s speech change anything? No. All it did was make more time go by that allowed the indicators to register even worse readings. Thank you, Draghi!

This is just a great example of how, in addition to our technical analysis, the goal should be to keep an eye on these reliable indicators and oscillators consistently over time. That way, we can avoid head fakes; we can eliminate acting prematurely on signals that we think will occur because of our own hidden bias in a certain direction.

We all would like the perfect “Holy Grail” to the systematic approach that allows us to think and act without emotion — but the bad news is that simply doesn’t exist. However, we do have the next best thing with these indicators and oscillators.

Now that we have the information, here’s how I recommend playing it:

“Buy to open” TZA at current levels, currently in the $18s. The Direxion Daily Small-Cap Bear 3X Shares (NYSE:TZA[3]), as its name suggests, trades opposite the small-caps; this goes up when the Russell 2,000 goes down. I also recommend you take profits and sell to close when TZA hits target $30.

  1. that day’s remarks from ECB chief Mario Draghi:
  2. IWM:
  3. TZA:

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