Market Outlook as at February 6, 2007

I've written earlier that we need to look out for signs of an overheated market to reduce our position. These signs include the CI persistently testing the upper Bollinger Band & an unsustainable surge in volume traded. Well, we have seen the former & today, we could be seeing the latter. As at 4.00 p.m. today, the volume traded in the market was 1.65 billion units. For the whole day, the volume traded could amount to 2.0 billion units. The last time we had a 2.0-billion units day was on Dec 6 (actual volume: 2.2 billion units) and then the market peaked on Dec 12 (3 trading days later).


Chart: CI's daily chart as at Feb 5

The other thing to note is that the CI has been "gapping up" for the past 2 days as well as today. A gap is formed when opening price movements create a blank spot on the chart. A “gap up” occurs when the low of the day is above the high of the previous day. Gaps are especially significant when accompanied by an increase in volume.

There are 3 types of gap i.e. common gap, continuation gap & exhaustion gap. For now, the big question is whether we are facing continuation gaps & exhaustion gaps. From Stockcharts.com, we have the definitions of these types of gap:

• A continuation gap forms in the middle of a move and in the same direction as the current move. These gaps signal a continuation of the preceding trend and can mark good entry points. After a short or intermediate advance, a continuation up gap is usually considered bullish and signals a renewal of the uptrend. After a short or intermediate decline, a continuation down gap is usually considered bearish and signals a renewal of the downtrend. This gap is also called a measuring or runaway gap.
• After an extended or long move, a gap in the direction of the current move is called an exhaustion gap. For an exhaustion gap to be considered valid, prices should reverse soon after the gap and close the gap. After an extended decline, a gap down could signal that the downtrend is about to exhaust itself. An exhaustion gap is confirmed when prices reverse soon afterwards and move above (or "close") the gap. After an extended advance, an exhaustion gap would be confirmed when prices reverse soon afterwards and move below the gap.

If you feel that the market has had an extended run-up and the current gaps up is likely to be exhaustion gaps, the better course of action is to reduce your position. On the other hand, if you feel that the current gaps up is a renewal of the uptrend (maybe due to new buyers coming into the market such as foreign funds), then your course of action would be totally different. You would be buying into the current rally. Personally, I think that it is likely to be exhaustion gaps and would choose a prudent course of action.