The Rubber Band Is Stretched

 | Feb 17, 2013 | 10:30 AM EST
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Remember when Homeland Security would raise their alerts from "guarded" to "elevated?" That's a fitting analogy to what I'm seeing in the market, and it's the reason I've been putting out alerts that suggest we need to protect profits on any current long positions. I even put together a video illustrating, over the years, how many S&P 500 moves have terminated temporarily at extensions of prior swings.

What really gets me watching an index (or stock) for possible failure is when the price meets the minimum target for most of my trade setups -- that is, the 1.272 extension of the swing into the setup zone. An example of this is when the S&P 500 hit a low on June 4 of last year, finally reaching the 1.272 extension at 1464.71. When this happened, I had to consider that the S&P was vulnerable to a healthy downside correction.

S&P 500 -- Daily
Source: Dynamic Trader

At that time, the index did end up trading a bit higher into another price projection. But, soon thereafter, it embarked on a 131.16-point decline into the November 2012 lows. However, because we were aware of this possibility, we were poised to trade into the pullback when it actually began in earnest.

I find the market in a similar place today, as the S&P has now reached the 1510 handle -- the minimum upside target off the November 2012 lows -- and is starting to approach target 2 around the 1555 handle. At the same time, we are also looking at a confluence of Fibonacci timing cycles that tell us the odds for a corrective decline are higher than usual.

S&P 500 -- Weekly
Source: Dynamic Trader

The above chart illustrates a cluster of Fibonacci timing cycles the S&P is currently testing -- they are due between now and the week of Feb .22. (If the chart looks familiar, it's because I have posted it before in Columnist Conversation.)

Bottom line: We're seeing a "warning" for a potential corrective decline -- one that's coming from both the timing and price axes of the market.

But does this mean we need to exit the market or that we should short it? No. Rather, this basically tells us we should trail up stops a bit closer than usual and be prepared -- on proper reversal indications -- to either exit positions and/or turn it around for a trade. I'm not trying to call a crash here, but the rubber band is a bit stretched here at current levels.

Here's one thing I've been watching every day: the five- and 13-day exponential moving averages on the daily chart. Right now, they are still in a bullish position. One of the first indications that this rally may be over, at least temporarily, will be when the five-day EMA crosses below the 13-day on the daily chart.

So this market could very well continue to rally, as participants who continue to expect a decline may fuel another spike up with their short positions. But, in my daily updates, I continue to call myself a cautious bull. I have overused this phrase almost as much as CNBC harped on "fiscal cliff" -- but, even if I do sound like a broken record, I would rather be safe than sorry, and remain on alert to a possible failure in the next couple of weeks.

In the meantime, for the past few weeks I have continued to set up trades that involve buying on pullbacks, and I'll continue to do so until this market tells me the tide has turned.

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