By Ken Goldberg at The Street
History is poised to repeat itself in the stock market, and the result won't be pretty for the bulls. Last week we noticed a pattern in the PowerShares QQQ Trust(QQQ) that is eerily similar to one that occurred late last year and preceded the stock market's worst January ever.
This pattern is called a "gap island reversal," and it marks the end of a previous trend and the beginning of a new one. Look at the intraday bar chart below of the PowerShares QQQ Trust, the exchange-traded fund that tracks the Nasdaq 100 index. Notice the large pink box at the top of the graph? It's not attached to the price bars to its left or to those to its right. This "island" of price behavior began with a gap higher on Oct. 23 and ended with a gap lower on Jan. 4. This formation shows exhaustion, and in this particular case, it revealed exhaustion of the final rise off the August panic spike reversal.
Now look at last week's activity. Although last week's high came within a few cents of the Dec. 31 low, it failed to fill the gap to that low. This is an "uh oh" moment, when the crowd realizes it's been trapped into late-joining buying, mostly because of the gap that began the island formation.
Investors who buy stocks in these green boxes are operating under the coping mechanisms of denial and rationalization: denial that the market is hitting historical extremes and rationalization that there will always be a "greater fool" to buy stocks from me at a greater price than the one I just paid.
We prefer to rely upon objective analysis from our decision support engine, which is is designed to identify historical cause-and-effect relationships. It helps us avoid emotion-based actions. We share this analysis with members of our Live Alertsservice.
Now take a look at the bottom pane of the chart, which tracks stochastics. On the left there's a yellow box that corresponds to the large pink box in the upper pane. That yellow box shows that stochastics were making lower highs even as the PowerShares QQQ Trust was making higher highs in price. The bold blue line in the yellow box traces those lower highs. The bold blue lines in the big pink box show the voracity of the price behavior after the initial gap, which weakens significantly into the final high in price, followed by a lower price high, then the reversal. In this particular case, the reversal took the form of the mini crash from the December high to the February low.
Here's where the decision support engine really shines. The little pink box at the upper right reveals the "gap island reversal" pattern that was formed by Friday's opening gap. This is a mini version of that same pattern in the big pink box. Although this pink box is smaller, look below the current mini island and see the yellow box. This us where the stochastics have created another bearish divergence sell signal by making lower highs even as the ETF was making higher highs in price. What is interesting is that the size of the two yellow boxes is identical. This means the technical deterioration of the rise off the February low is as glaring as it was at the previous pink box, but this waning of upside momentum, breadth and bullishness occurred after a much smaller rally, and reversed after a much smaller "island."
We use these warnings from our decision support engine's hunter/seeker algorithms to ask ourselves the objective decision support question, "If I had no money in the market at all right now, would I jump in with fresh money with buying or selling actions now?"
The answer is that buying actions are not indicated and selling actions are.
Therefore, you should use $108 as a stop-loss level for long exposure to the PowerShares QQQ Trust. This is to avoid the "uh oh" effect that is likely again, if you used coping mechanisms last week to deny or rationalize the greater fools theory, and bought in the small pink box. If you're flat, you can set up short exposure on a close under $108, as well as back into the pink box, using $111 as the level for protective buy stops. You may also want to use the $108 level on the PowerShares QQQ Trust as your signal to exit other stocks.
Notice that $111 is the current equivalent of the $114 level, which was the line that the first gap island reversal pattern would have had to break to negate the bearishness of that massive pink box.
Bottom Line: This $108 area is likely an ideal zone to be exiting the PowerShares QQQ Trust and other stocks.