The Red Flags are Flying High

Investors are beginning to see some life return to tech stocks. If you look at the charts, a bullish double bottom surfaced between mid-April and early May. In the process, the short-term trend has been bullish, as the index broke out of its previous downward channel that was in effect from January to May. The tech-laden NASDAQ has closed higher in 10 of the last 11 sessions.

 A look at the percentage of stocks trading above key moving averages further points to the improved market sentiment. For instance, 63.29% of stocks are presently trading above their key short-term 50-day moving average, compared to 26.64% a month earlier. A look at the key 20-day moving average shows 72.41% trading above, versus 37.53% a month ago.

 That’s all fine, but should you jump in with reckless abandonment? You might have already done so or perhaps you’re itching to take that jump. In any case, I believe that you need to remain cautious when trading the current uptrend.

 You could be thinking that I must be losing my mind by not following the trend. Consider this. The current trend could be a false breakout, designed to play with your mind and sucker you into increasing your trading.

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 So, while the NASDAQ’s break higher is encouraging, there are some warning flags on the charts. A significant issue continues to be the lackluster buying on rallies.

 In the first 19 trading days of 2005, daily trading averaged over two billion shares. But trading activity since January has been relatively low. In the 81 sessions since, daily trading has come in below two billion in 69 sessions or 85% of the time. Trading for the five-day period to May 27 was a paltry 1.57 billion shares, versus 1.74 billion shares the prior week. This does not confirm a sustainable rally – it’s what I call a bearish divergence. The five-day moving average is well below the 30- day and 200-day moving averages of 1.72 billion and 1.76 billion shares, respectively. This tells us that the money of the herd is not chasing stocks. If you read some of my past commentaries, following the money flow is critical to gauging the true underlying sentiment.

 Another red flag is based on the CBOE NASDAQ Volatility Index or VXN – a barometer of near-term market volatility based on NASDAQ 100 index option prices. The VXN is generally viewed as a contrarian indicator for trading.

 A high VXN indicates maximum fear and a possible market bottom. A low VXN indicates reduced apprehension and a possible market top. So, where are we now?

 The five-day VXN to May 27 fell to 15.68, versus 18.36 the prior week. It is below the 30-day MA of 18.38, as well as the 50-day and 200-day MA of 18.01 and 19.31, respectively. The chart shows a declining VXN over the past several weeks and is currently at its lowest point in over six months. The contrarian view suggests a market top for the NASDAQ may be in the works.

 As the NASDAQ edges towards key resistance at 2100, watch the trading volume and volatility. So far, it suggests an unsustainable rally. Watch for the red flags ahead, and stay on the side of caution.