“Are we there yet?” If you are a parent you’ve no doubt heard this question.
Kids can be impatient and don’t read maps or GPSs, so the question makes sense.
Investors often ask themselves a similar question. Instead of “are we there yet?” they ask, “how much up side potential is there?” or is the stock ‘there’ (at its peak) yet.
The closest thing to a GPS for stocks are trend lines. Trend lines outline the path for stocks, indexes or ETFs.
The chart below shows a parallel channel for the Russell 2000 Index (Chicago Options: ^RUT).
At first glance it looks like the Russell is ‘getting there’ or approaching a possible top.
Like a tenacious woodpecker, the Russell 2000 keeps chipping away at parallel channel resistance without out actually penetrating.
This hasn’t hurt performance. Since the channel is ascending, the Russell 2000 can continue higher without ever breaking above the channel. But we see that almost every touch of the upper channel line (red circles) caused a temporary pullback.
The rally from the November 2012 and June 2013 low has been very steep and with all things that are too good to be true, the Russell will eventually give back some (or most?) of its gains.
RSI (gray circle) is already showing signs of fatigue. Although this is a small warning signal, RSI can lag for months and RSI-based sellers may miss a big portion of a rally.
The chart for the iShares Russell 2000 ETF (NYSEArca: IWM) and Vanguard Small Cap ETF (NYSEArca: VB), although not as crisp and clean, look very similar to the R2K index.
Since the Russell 2000 has outperformed the S&P 500 (SNP: ^GSPC) to the up side, it will probably outperform the S&P 500 to the down side. Now don’t go out and short the R2K or S&P right now, but you may mentally prepare for a possible shift from an up to down trend.
How To Spot a Top
Stretched rallies have a tendency to flame out with a trend channel over throw, where prices stage one last hurrah and spike above the channel. A close back below the channel often concludes the rally and kicks off a prolonged decline.
Any decline has to be confirmed by a drop below resistance, which didn’t happen in April and June (green circles).
The ETF Trade SPY is a free weekly feature that identifies ETFs near major inflection points created by support or resistance levels.
Prices near support/resistance levels tend to be great setups for low-risk trades. Why low-risk? Support/resistance is used as stop-loss and is an effective risk management tool.
If you only enter trades where your potential gain is bigger than your potential loss, you win.
To receive future issues of the free ETF SPY follow iSPYETF on Twitter @ iSPYETF.
ETF SPY History
XLK: July 24, 2013, ETF SPY predicted higher prices for XLK. Click here for XLK support and target levels.
Dow Theory: July 19, 2013 ETF SPY predicted higher prices for Dow Jones Industrial and Dow Jones Transportation Averages.
XLF: July 12, 2013 ETF SPY predicted higher prices for XLF along with a price target.