Stock Traders: Switch Bias To Neutral Or Bearish Mode

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 |  Includes: DIA, IWM, QQQ, SPY
by: Capturetrends

The market fundamentals and technicals are showing that it's time for bulls to turn cautious on the long side and at least book some profits on their positions. The bears, on the other hand, might begin initiating some short positions, hoping for the markets to sell off a bit.

Interest rates are a key factor in the direction of the stock markets, and they have been rising. Interest rates on key US Treasury bonds have risen since October 2011 as their prices dropped. Interest rates are inversely related to bond prices.

Click to enlarge.

30-year US Treasury Bond FuturesClick to enlarge

The 30-year US Treasury has dropped 5% from it's peak at the time of writing this article. The 10-year has dropped about 1.7% from its peak. These may not seem like huge drops for equity market traders, but they are considered substantial by bond investors.

10-year US Treasury futuresClick to enlarge

A better guide to the turmoil in the bond market is the 20-year plus treasury bond exchange traded fund, TLT. The fund has fallen nearly 10 percent from its peak.

20-year Treasury bond fundClick to enlarge

In fact this week, bond investors have pushed up interest rates on Spanish and French government borrowing. As interest rates rise they put a downward pressure on the equity market. Investors find it better to hold bonds as their returns improve over the riskier equity instruments.

Despite the huge deficits piled up by governments across the Western Hemisphere, interest rates have stayed low due to the monetary easing by central banks. Now central banks seem to be pulling back with the European Central Bank focused on inflation and the US Federal Reserve giving no indication of further bond buying. The result is falling bond prices and rising interest rates.

But remember the interest rates in the US treasury market had begun climbing last year, but the equity markets continued to rally. There is a reason for this. Initially, when bond prices start to fall investor move from bonds to equity. This pushes up equity prices. But a sustained rise in interest rates increases the fear of a economic slowdown, which leads to a equity market sell off.

The point where the rising interest rates trigger an equity market sell off might have been hit. This happens when investors believe that the equity market is overbought. That certainly seems to be case when one looks at the technicals of the market. The Nasdaq 100 has reached a key area of resistance dating back to January 24, 2001, when the Nasdaq 100 futures contract rallied to touch 2800 and they sold off to touch a low of 800 in October 2002.

After that point the Nasdaq 100 has been going up slowly and in fact leading the markets up. Even during the last bear market of 2008, the Nasdaq did not go below its October 2002 low, unlike the S&P 500 and Dow, clearly indicating that the tech index had relative strength to the broad market.

Now that Nasdaq 100 has reached a level of resistance, it's likely to turn again. Please check out the chart below. The first chart shows where the prices now, with support levels where the tech index can catch a bounce, in case of a sell off. The second chart shows the turning point in 2001.

NASDAQ 100 nowClick to enlarge

Nasdaq 100 resistance level in January 2001Click to enlarge

Previous turning points or levels of consolidation often act as turning points again. To prove the point look at the long term chart of the S&P 500. It fell in October 2007 near its previous peak in March 2000. It also rallied in March 2009 where the index consolidated from February 1996 to September 1996 in the range of 630 and 680.

These levels tend to work on both long and short time frames. Prices are fractal, and price action on a 5 minute chart is similar to movements on the monthly chart. Only the ranges are different.

Hence, it will be a good strategy for bulls to book profits on their long positions or least take part of their positions off. Bears can take short positions on the Nasdaq 100 with stops above 2825. The profit targets for short positions are the support levels shown on the chart above.

Also note that Nasdaq is the index leading all the markets up. Once the leader hits resistance and begins to fall, the lagging indexes, such as the S&P 500, Dow and Russell 2000, can fall faster. So it might make sense to short one of those to get a better bang for the buck. Traders not trading the futures market can trade the exchange-traded funds instead. For the Nasdaq 100, they can trade QQQ, for S&P 500 the SPY, for Dow the DIA and for Russell 2000 the IWM.

It's always possible that the Nasdaq 100 could break out and rally higher, in which case one can just take a stop loss and switch to a bullish position. A break out of 2800 can take the NASDAQ 100 futures contract all the way up to 3000. But that is most likely to happen only after a decent pull back.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.