Looking to the Semiconductors to Lead the Way - Phases Versus Channels

July 19, 2010

Mish's Daily Articles

By Mish Schneider

One distinct reason the market is confusing to many trend traders right now, is clearly illustrated with the chart of the SMH or the Exchange Traded Fund for Semiconductors. Semiconductors took a divergence from the "Death Cross" of the SPY chart by entering a bullish phase.

If one measures how moving averages line up, the SMH confirmed a bullish phase on July 12th as the price rose above the 50 day moving average, which is stacked above the 200 day moving average. Furthermore, the slope or direction of those moving averages is pointing upwards. Certainly, many semiconductor stocks did well last week as the market rallied. In fact, they led the way. Even on Friday, with the huge decline of 261 points, SMH fell by 2.2%, but managed to hold onto the bullish phase by testing, but not penetrating the 50 day moving average. Even more compelling, is that the adaptive moving average began to slope up the week prior to last week and then on Friday July 16th, crossed over the 200 day moving average. Although we find this encouraging that a rally might resume in this group and sector if the market consolidates (or at the very least continues a kinder, gentler selloff), we must step back and look at the overall chart pattern. SMH is in a high and wide channel-with a descending channel line, indicating a bearish channel.

Our ETF Monitor-below-as of the close on July 15th, shows the SMH as Bullish with a 6 month average weighted return of 1.17%. Semiconductors are one of the top sectors. Without claiming to be an economist, I do know from our back testing, that these trends tend to last an additional 6-9 months. That's why it's so important to identify not only the overall market condition, but also the leading sectors, groups and their strongest components. With this information, from a fundamental viewpoint, one can make a case to be long SMH expecting a long term positive result.

ETF Monitor

But we are technical traders.

What is a price channel? A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower trend line. The upper trend line marks resistance and the lower trend line marks support. Price channels with negative slopes (down) are considered bearish and those with positive slopes (up) bullish. For explanatory purposes, a "bearish price channel" is a channel with a negative slope.

SMH Chart

The example chart of SMH has its high and wide channel defined. And, with a slightly negative slope, can be considered a bearish price channel.

To draw the channel lines, I took the extreme lows (you need at least 2 points), then created a parallel from that and dragged it up to the high points (the middle high or one of the critical points) of the channel top and drew a parallel line.

Currently, SMH is in the middle of this high and wide channel. Analyzing the moving averages and phases is powerful but one can see that if the chart pattern is overlaid, SMH is now trading within the middle of the channel. So, one would think that if the price breaks the channel either to the up or downside, the move would be powerful. But actually, the reverse is true. The wider the channel, the less velocity the break up or down is. Tight and narrow channels generally have more follow through. The more the energy is consolidated, the more forceful the breakout or breakdown is. On the other hand, with a high and wide channel, if the price breaks out from either the up or downside of the parallel lines and then proceeds to trade back into the channel-a trap is often set for the bulls or the bears. In the case of a bearish channel, if SMH breaks below the low of the channel lines and comes back into it-that would be considered extremely bullish.

Here's why. In late June, the decline from the top of the channel was rapid and when the lows were finally penetrated, most of the energy had dissipated which sucked in weak shorts. A triple bottom formed. Then, it moved up equally fast, that as buyers came in, they too could not get the momentum for a sustained rally, thus a triple top was formed. Currently, we have cleaned out both the longs and shorts. What should we look for now? Best case scenario-a consolidation at either the low or high end of the channel. Then buy or sell the breakout or breakdown of that consolidation. In other words, we want tighter compression within the channel, closer to its bottom or top.

Happy Trading!

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