Wednesday, November 11, 2009

4045.11

Well, what has Dow Theory been telling us lately? Generally speaking, we have been in a "non-confirmation" status for the last couple of weeks. The Dow itself has risen through a series of new highs for this rally. Meanwhile, the Dow Transportation Average has not followed suit. In fact, from October 21 through November 2, the Transports were down dramatically. Since then, they have failed to rise above their most recent high, recorded on October 20 at 4045.11.

For several days recently the Transports have been down while the Dow has been up (yesterday, for example). According to Dow Theory, such divergence is a sign of market weakness, a possible signal of a correction to the present rally.

The recent battle for the 10,000 level in the Dow has been interesting to watch. So many forces are in play. Is this a
bear market rally or a new bull market? Will the future be dictated more by the forces of deflation or inflation? A case can be made either way.

Since early this year I have had my eye on the 10,300 level for the Dow. 10,300 is roughly the mid-point between the lowest low in March and the highest high for the Dow back in October 2007. According to Dow Theory,
the 50% Principle is best applied to longer-term swings in market activity. The longer the period taken into account, the more significant the level.

For example, the calculations above reflect the 50% Principle over the course of the last 25 months. If you take a broader view of the rally from 2002 through 2007 (roughly 60 months of activity) the mid-point between the low in 2002 and the high in 2007 brings you to 10,725. By the definition of time, this mid-point is weightier than the 10,300 level which takes a comparatively shorter period of time into account.

So, since I entered the market again in January and added to my holdings in the Dow, S&P, and Gold ETFs, I have been looking (hoping) for a rally into the 10,300 area. If the Dow could make this level (and for a short time it looked as though the Great Recession would not allow this to happen) then it would be time to see if it could advance just a bit further. Closing above the 10,725 mark would strengthen the case that we are in a new bull market.

The strongest technical indication that we are possibly in a sustainable rally comes from the Dow's recent history with the 50-day
moving average. Since rallying up to the 50-day MA on March 23, the Dow has "tested" the average three times. The first time, between June 22 and July 15, it actually went below the average - a sign of weakness. But since then it has touched the average on October 1 and again on November 2. Each time the Dow has "bounced" off the average, indicating strength in momentum.


Compare the Industrials (top) and the Transports (bottom) over the past 3 months. Each candlestick is one day's activity. The blue lines are Bollinger Bands. The tan line is the 50-day moving average. Notice how both averages have quickly rebounded when they tested the 50-day MA, though the Transports have clearly been the weaker of the two. Still, such rebounds are a possible sign of strength. (Charts made at BigCharts.com).

Of course, by itself, this doesn't mean a new bull market is in force. It simply means the short-term trend is positive. No reason to get out of the market.

When looking for a correction it is best to shift perspective away from the 50-day MA to the 200-day moving average. History tells us that this broader average has to be retested at some point. Currently, that average is at about 8700.


The greater the distance between the 200-day MA and the actual market close, the more violent the "snapback" will be toward the average when a genuine correction occurs. We saw this happen most recently in March when the distance between the MA and the Dow was over 3000 points! There was a short, sharply positive correction. Then the market stalled at the 200-day MA for a couple of weeks before resuming its current rally. Fortunately, at the moment the situation isn't that extreme. Still, the difference is currently 1500 points with the Dow above the average.

In the broader view, over the last decade the longest the Dow has gone without returning to the 200-day MA has been from April 29, 2003 to May 10, 2004 and from August 11, 2006 to August 16, 2007. Those were both bull market periods. The recent bearish activity took the Dow below the 200-day MA from May 20, 2008 to June 3, 2009. These are all exceptionally lengthy periods.


The 200-day MA (see tan line above) since mid-February. Notice the recent uptrend after leveling off in July and August. A positive sign. Also notice the gap between where the Dow actually fell in March and the 200-day MA. A huge, ahistorical gap. The "snapback" then occurred with the Dow stalling at the average in June. Then a powerful upswing which is carrying on through today. But the 200-day MA moves slowly compared with the 50-day MA. So as the market rises quickly the gap between the 200-day MA and the market widens. Another snapback possibility? The market never strays too far from this average for long.

Before the Great Recession took the Dow so far away from the 200-day MA, the Dow has remained within less than 1000 points of the 200-day MA for all but a handful of days throughout the last 10 years. In other words, it is highly unusual for the Dow to be as far above or below the 200-day MA as it is today.

That is reason for concern. Which brings me back to the Transports and the 4045 level. If the Transports can better that level simultaneously with the Dow going to a new high, then we will most likely be in for an extended period above the 200-day MA as we had in the years mentioned above. Basically, this would signal a new bull market.

If the Transports breakdown again, however, and fail to better the 4045 level - regardless of how high the Dow might go - then we will likely have a correction back toward the 200-day MA.

Obviously, a lot of variables are in play here and we are in a complex, historic situation with all this stimulus money being generated out of thin air. But, my instincts tell me to watch the Transports. Failure to "confirm" new highs in the Dow will give more weight to the Dow Theory non-confirmation.

Even though the
Dow closed at a new high for the rally today, the continued non-confirmation by the Transports makes a "snapback" correction even more likely. Factoring this non-confirmation into the complex mix of the actual state of the economy, a significant number of bank failures, gold setting a record high (great for me!), the housing crisis, the US trade deficit, the unprecedented dumping of liquidity into the system, the massive rise in deficit spending, and the continuing rise in unemployment might make the potential for more gains too risky compared with the potential for correction. The Transports should offer us guidance.

But, of course, no one knows.

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