Divergences Deepen Potential Pullback

The price action and the underlying technical condition in the equity market continue to diverge, which can ultimately slams the indices much more than expected. But for now the bulls continue to control price direction.

Examining the Nasdaq through its QQQQ tracking stock, from a near-term perspective both the pattern and RSI oscillator configuration off of the July lows at 35.60 into Friday's high at 40.45 argue that the Q's are ripe for a period of backing and filling into the 39.50 area -- at the very least -- and perhaps a move that revisits the 9/11 upside pivot point at 38.32.

Yes, yes, I am fully aware that the price action does not exactly "feel" like the Q's can or will break micro support at 40.00-39.95. However, the prior two similar 4-hour "set-ups" resulted in pullbacks (within the developing uptrend) of $1.06 and $1.16. With that in mind, we should look for a decline from 40.45 to the 39.50 area to recharge the upmove.

Given, however, the fact that this set-up represents the second RSI divergence off of the 8/17 rally peak at 38.98, then the potential for more than a decline of $1.06-.16 is a mounting likelihood.

Should a deeper correction unfold, 39.00-38.30 would be considered the optimal target zone. Moving over to the S&P 500, for a slightly different view of the intermediate-term technical conditions let's overlay Bollinger's Bands on the SPDRs (SPY) daily chart. Notice that at the top band the price structure usually has exhibited upside continuation problems, and either has stalled or otherwise been subjected to weakness. When juxtaposed against RSI and ADX (directional trend strength gauge), one wonders if the current rally is a bull trap of traps?

The blue arrows identify price confrontations with the upper Bollinger Band, which in every case triggered a pause, pullback or severe downside reversal. Given that the accompanying oscillator shows a glaring momentum divergence at current highs (132.20-.45 area) AND a very weak uptrend (ADX) in force since the 9/11 low, a pullback should be forthcoming in the upcoming hours-days.

Initial support in the SPY on this chart is 131.00-130.80.

While equities are due to pullback, oil looks higher. Nearby crude oil futures prices have rallied $2 off of Friday's new reaction low at $62.03, and currently are pushing up again a 3-week resistance line. If this line is hurdled and sustained, that should trigger upside acceleration towards my optimal recovery rally target in the vicinity of $66.

Should such a scenario unfold, then after a recovery bounce to $66, prices should loop down for a retest of $62 prior to embarking on a much more powerful advance.

Mike Paulenoff is author of the MPTrader.com ETF Trading Diary (www.mptrader.com), a real-time diary of his technical analysis on equity markets, futures, metals, currencies and Treasuries.