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Get Ready for Another Flash Crash

By Jeff Clark
Thursday, September 23, 2010

This is an amazing chart...
It's a 60-minute chart of the S&P 500. You can see the bearish rising-wedge formation on the chart, and the negative divergence on the moving average convergence-divergence (MACD) momentum indicator. Both of those argue for an imminent downside reaction.
That's not the amazing part. After all, we've seen plenty of these chart setups this year.
The amazing part is in the stochastics graph at the bottom of the chart.
Stochastics measure overbought and oversold conditions. Chart readings below 20 indicate a stock or index is oversold. Readings above 80 suggest the stock or index is overbought.
Extreme conditions can persist for a few days. It is rare, though, for stochastics on a 60-minute S&P chart to remain oversold or overbought for more than just a few days without seeing some sort of reverse price action.
Even during the remarkable uptrend this past March and April, when stocks were persistently making higher highs (and I was banging my head on my desk in frustration), the 60-minute stochastics measurement never stayed overbought for more than a couple days.
During this current stock market rally, however, the 60-minute stochastics hit overbought levels on September 2, and they stayed there... until finally turning lower yesterday. That's a remarkable 12 trading days in overbought territory.
I don't know if I've ever seen that before.
If this were happening with high volume and persistently negative investor sentiment, I'd have to throw my hat into the bullish side of the ring and bet on higher stock prices through the remainder of the year. Strong moves accompanied by high volume confirm a trend and increase the odds of it continuing. And negative investor sentiment is a terrific contrary indicator.
But we're not seeing that with this rally.
All the Wall Street bigwigs are back from their Martha's Vineyard beach houses. But volume remains anemic. And investor sentiment – which was horribly bearish just two weeks ago – is now more bullish than it was back in April, when stocks were making their highs for the year.
This is a bad deal. There's no other way to put it. Stocks are rallying in the face of weakening technical indicators. The price action is strong and bullish. But without the support of the underlying technical indicators, this rally is doomed to fail.
That's what happened in May, just before the "flash crash." That's what happened in mid-June, after a strong bounce off the retest of the May bottom. And that's what happened in August, after the market ran up 9% in July.
It's always dangerous to try to pick a top (or call a bottom) for the market. After all, stocks were overbought last week, yet the market has continued higher. This is, however, the type of environment in which price reversals can occur suddenly and out of nowhere – where the stock market gaps lower on the opening and never bounces, and where another "flash crash" is possible. If you don't have a short position in place before the move, you won't get an opportunity at a low-risk entry level.
It is the type of environment in which it makes sense to own some speculative put options. I'm not talking about loading the boat on the short side. The environment is still too muddy and trendless to make big bets in either direction. But given the overbought condition of the market, and the potential for a sudden and swift selloff, I like the odds of a put trade.
Best regards and good trading,
Jeff Clark

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Market Notes
Gold hits another record high above $1,290... Fed says it will support inflation.
Inflation also means higher food prices... new highs for Anheuser-Busch, Coca-Cola, and Kraft.
Dozens of big tech names up more than 15% in September, including Oracle, Amazon, and Apple.
Warning sign for tech rally... Adobe plunges 20% on slightly weak guidance.
Market Watch
Symbol Price
S&P 500 1124.83 -0.8% +6.0%
Oil 32.67 +0.3% -7.0%
Gold 126.30 +0.1% +27.8%
Silver 20.66 -0.2% +24.9%
US-Dollar 80.07 +0.4% +4.7%
Euro 1.33 -0.6% -9.6%
Volatility 23.87 +6.0% +1.6%
Gold Stocks 504.92 -1.0% +22.2%
10-Year Yield 2.56 +0.4% -25.2%

World ETFs
Symbol Price
USA 112.50 -0.8% +6.0%
Canada 27.30 -0.7% +6.2%
Russia 19.05 -0.3% +1.3%
India 35.55 -1.6% +24.5%
Israel 15.99 +0.6% +15.4%
Japan 9.74 -0.4% -3.5%
Singapore 12.95 -0.7% +21.1%
Taiwan 13.20 -0.1% +9.7%
S. Korea 51.80 -1.2% +9.7%
S. Africa 64.60 -0.6% +16.7%
China 41.89 -0.8% -1.0%
Lat.America 48.72 +0.1% +16.3%

Sector ETFs
Symbol Price
Oil Service 107.68 -0.9% -8.7%
Big Pharma 64.73 -0.4% +0.6%
Internet 62.62 +0.1% +24.3%
Semis 12.34 +0.3% -4.6%
Utilities 30.96 -1.2% +5.5%
Defense 16.82 -1.2% +3.2%
Nanotech 8.64 -1.4% -21.2%
Alt. Energy 9.27 -0.2% -16.7%
Water 15.99 -1.1% -6.5%
Insurance 15.02 -1.6% +10.1%
Biotech 18.94 -0.6% +11.2%
Retail 17.05 +0.1% +9.9%
Software 22.08 -0.4% +15.0%
Big Tech 48.67 0.0% +14.7%
Construction 11.54 -0.9% -6.2%
Media 11.93 -0.4% +12.4%
Consumer Svcs 59.81 -0.9% +14.5%
Financials 51.38 -2.0% -3.2%
Health Care 62.63 -0.8% +6.7%
Industrials 56.43 -2.1% +10.4%
Basic Mat 63.47 -1.2% +13.4%
Real Estate 52.12 -3.1% +19.7%
Transportation 79.19 -2.3% +11.4%
Telecom 21.36 -1.1% +14.2%

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