It is said that a picture is worth a thousand words.
As such, there are times when investors can learn an awful lot about the state of the market environment simply by scanning the charts of major stock market indices. And cutting to the chase, this is definitely one of those times.
Some will argue that Friday's weakness was related to concern about the debt ceiling debate taking place in Washington. The fact that the Republicans in the House pushed through a measure that "defunded" (is that even a word?) Obamacare as part of a continuing resolution to fund the government until Dec. 15 certainly adds to this argument.
Since everybody on the planet knows that the bill has no chance in the Senate, the move can be viewed as just another effort to up the level of gamesmanship (which is likely to lead to brinkmanship) between the two parties. Therefore, some traders fear that the debate will once again threaten the fragile economic recovery.
Another argument regarding Friday's sudden swoon was that all the good news is now out. The Fed didn't taper. Larry Summers withdrew his name from consideration. And Syria is out of the headlines. So after a surprising run to the upside, some backing and filling would be a logical next step for the indices.
Then there were the issues of an expiration Friday and the Dow's rebalancing, as three old-school names were booted from the venerable index. Some argued that this combination allowed the algorithms to play even more games with the market than usual.
In any event, it appears that some sort of a pullback is under way. The question, of course, is if the pullback that got rolling on Friday will be a one-day wonder or something more serious.
As the technicians like to say, "The tape tells all." So, in an effort to find some clues as to what might transpire next, let's take a look at some charts.
Let's first take a look at the daily chart of the S&P 500. This is the index that most technicians follow and therefore can be viewed as a picture of the overall "market."
S&P 500 Index Daily
Sometimes it is best to use a K.I.S.S. (keep is super simple) approach when reviewing charts. While Friday's decline wasn't a happy event for the bulls, the S&P remains above the August high, which is an important technical line in the sand, as well as is shorter-term moving averages. And all three of those moving averages are moving higher. In addition, there is an uptrend line that can be drawn from the November and June lows. Thus, the bottom line is the trend remains bullish at least at this stage.
The next step is to look for confirmation among other indices. So, take a moment to scan the following charts using the criteria that was applied to the S&P 500.
NASDAQ Composite Index Daily
For the Nasdaq, the same situation can be seen. This chart is actually in better shape than the S&P's as Friday's pullback was less severe. The bottom line here is the index remains in an uptrend, is well above the August high, and is nowhere near its short-term moving averages or trend-line. In short, it's all good.
Russell 2000 (Small Cap) Index Daily
Ditto for the Russell 2000, as the market-leading small cap index remains in pretty darn good shape.
However, the "picture" painted by the Dow Jones Industrial Average and the Midcaps is very different. Take a look.
Dow Jones Industrial Average Daily
Uh oh. This daily chart does not look nearly as good as the S&P, Nasdaq and Russell. No, chart-watchers will argue that the DJIA failed to hold its breakout, broke important support, and appears to be tracing out a double-top formation. In addition, the short-term moving average has been violated. Therefore, the bears will suggest that the most likely next step is a trip down through the trading range to test support in the 14,800 area.
S&P 400 Midcap Index Daily
A similar picture is painted by the midcaps. This chart clearly shows a potential double-top and although the index remains above the short-term moving average, those seeing the glass as half-empty are likely looking for those gaps on the chart to be filled in the near term.
A Tale of Two Tapes
The problem is it appears that the charts are telling conflicting stories at this point. The charts of the S&P, Nasdaq and Russell seem to suggest that the trend is up and the pullback should be bought. Yet, the action in the DJIA and Midcaps argues that defensive measures should be taken and soon.
Generally speaking, it is usually a good idea to go with the message from the "league leaders," which in this case would be the Nasdaq and Russell since they are up the most on the year. In addition, the bulls contend that the action in the Dow should be discounted due to the rebalancing of the index that took place on Friday. The thinking here is that some of the move may have been artificial in nature.
So, those looking to place a bet on the near-term direction may want to continue to lean long. However, experience suggests that this may be a time to put away the crystal ball and simply try to stay in tune with what the market is doing for a while. In English, this means that it is time to let price be your guide.
Mr. David Moenning is a full-time professional money manager and is the President and Chief Investment Strategist at Heritage Capital Management. He focuses on stock market risk management, stock analysis, stock trading, market news and research. Click here to claim a free copy of Dave's Special Report on changes in the current market.