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I recently wrote about an important reversal pattern that occurred in the stock market.
Stock-market bulls’ expectations were that this negative pattern would be overwhelmed by stimulus unleashed by the federal government and Federal Reserve. However, the negative pattern persists.
This is a valuable clue for prudent investors. Let’s explore it with the help of a chart, followed by a conclusion.
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Chart
Please click here for an annotated chart of the Dow Jones Industrial Average ETF DIA, -2.62%, which tracks the Dow Jones Industrial Average DJIA, -2.71%.
Note the following:
• The chart shows the reversal pattern.
• The reversal pattern consists of the following components: 1. An “island reversal” that was formed by the two gaps shown on the chart. 2. An Arora sentiment indicator giving a “sell” signal near the top of the island. 3. Relative strength index (RSI) reaching an extremely overbought level while the island was being formed. 4. Heavy volume on a gap down. 5. An “inside day” following the formation of the island reversal.
• The chart shows that several attempts of stock market bulls to overcome an important reversal pattern have failed. The failure is indicated by the price not being able to move above the line market “resistance” on the chart and stay there for several days.
• The chart shows that volume has consistently stayed lower when the island was formed. This is a negative.
• In a separate pane, the chart shows the S&P 500 ETF SPY, -2.49%, which tracks the benchmark S&P 500 Index SPX, -2.58%. The pattern being traced by the S&P 500 after the island reversal is more positive compared with the pattern traced by the Dow Jones Industrial Average. This is a positive for the stock market.
• The chart shows two travel-related stocks, American Airlines AAL, -7.00% and Carnival CCL, -11.16%. The reason for including the two stocks in the chart is that they were some of the strongest performers when the island was being formed. They’re also popular stocks with the momo (momentum) crowd.
• As full disclosure, The Arora Report has taken advantage of the secondary share offering in American Airlines as a short-term trading position with a tight stop. This is not a long-term investment.
• The chart shows that American Airlines’ secondary offering was done at $13.50, a far cry from the $23-plus level that the stock reached when the island was being formed. Those who got carried away by the momentum and the possibilities of the economy opening are now sitting on a big loss.
• The chart shows that Carnival, after topping $25 during the island formation, has fallen to about $17, again causing big losses for those who got carried away with the momentum.
• The chart shows that Carnival’s bonds have been downgraded.
What does it all mean?
The sum total of the foregoing is the following:
• Investors need to be highly selective in new buying until this negative pattern is successfully overcome or the stock market pulls back.
• Investors should not get carried away with momentum and buy when certain stocks become popular with the momo crowd.
• Institutions are hiding in the big five tech stocks of Apple AAPL, -1.76%, Amazon AMZN, -1.08%, Microsoft MSFT, -2.01%, Alphabet GOOG, -2.21% GOOGL, -2.13% and Facebook FB, -3.39%. Investors should carefully watch those stocks.
Finally, the most important thing investors should do at this time is to follow the 12 principles described in “Here’s the secret sauce to handle the stock market’s election and virus fears.”
Disclosure: Arora Report portfolios have positions in Apple, Amazon, American Airlines, Alphabet, Microsoft and Facebook. Nigam Arora is the founder of The Arora Report, which publishes four newsletters. He can be reached at Nigam@TheAroraReport.com.
