Conflicting Signals

January 27, 2013 (6:00 pm)

Will the SPY melt-up rally continue, or will the dark shadow of a potential QQQ head and shoulders pattern give the bears the evidence they need to take over? Keep in mind that the next FOMC (Federal Open Market Committee) announcement is at 2:15pm on Wednesday. The market may not make a move until after that announcement.

The SPY Melt-Up: Since the resolution of the fiscal cliff on January 1st, the SPY has been in a well-defined uptrend. How will we know when the uptrend will break? Will it continue up forever? Let’s look at a few things here. There’s a large gap that remains unfilled. There should be minor support at $144.75 and $142.50. Below the gap is intermediate-term support at $139.50.

SPY Rising Channel

Near-Term SPY Rising Wedge: Over the last few days, the SPY has been forming a pattern that resembles a rising wedge. This is inherently bearish for the near-term. Further, this formed along with negative divergence, with rising price on weaker momentum.

SPY Rising Wedge

QQQ Consolidation: QQQ’s have been consolidating within a $1 range since the start of the year, barring a brief jump early last week that formed an island top reversal. Additionally, a 50% Fibonacci retracement of the recent rally would almost exactly bring the shares down to fill the gap. Keep an eye on the $66.00 and $64.25 intermediate-term support levels going forward.

QQQ Consolidation

QQQ Island Top Reversal: We briefly mentioned this earlier. Last week’s gap up and subsequent gap down created an island top reversal pattern. An island reversal is a chart formation where this is a gap on both sides of a topping or bottoming pattern. They frequently show up after a significant trend is in its final stages. This formation is an extremely good indicator of a reversal and tends to be most reliable if it occurs after a strong trend. We wrote a previous post on island top reversal patterns here.

QQQ Island Top

The QQQ Head & Shoulders: The island top reversal pattern comes at an interesting time. The QQQ’s have formed an incredibly well-defined head and shoulders pattern over the past year. The left shoulder was formed in March at the peak of the QE2 rally. The head was formed in September just as QE3 was announced by the Fed. The current post-fiscal cliff rally has formed the right shoulder. Interestingly, if the island top reversal is confirmed, it would likely form the apex of the right shoulder. The full head and shoulders pattern has a price target of $52, or a 22% decline.

QQQ Head & Shoulders

Conclusion: It seems as if many in the bear camp have begun to capitulate. The recent rally has driven some market participants to label it a “melt-up”, causing many to cover their shorts. Meanwhile, insurance is becoming increasingly cheap as demand for protection drops. The bearish set-up on the QQQ’s, however, leads us to view this protection as vital. Why not begin hedging when it’s cheap and there’s a clear bearish set-up? The next couple of weeks will create a clearer picture on where the markets are heading in the intermediate-term.