The 50-Day Moving Average as Support

In the last post, I addressed how the Dow-Jones Industrial Average (DJIA) failed at resistance. In cases where the DJIA is expected to fall from that level, how far can it be expected to decline? To translate this into technical analysis terms, where is the next support level? In the most recent situation, that support was at the 50-day moving average. The chart below shows this (click to enlarge).

Notice how the market moved all the way down to the 50-day moving average then "bounced" off this newly found support level. As of the time this post is being written the Dow is moving once again toward the prior resistance level.

Had the market fallen below its support at the 50-day moving average, where would it likely have fallen? Again, where are the next support levels? We should view the 50-day moving average as support level #1 (S1). Below that, the next support (S2) occurs around 10,900, then 10,700 is S3 (both of these are derived from horizontal support lines. After S3 comes the 200-day moving average at 10,600. Note, though, that the DJIA moved above support here when it was not yet overbought (the RSI never fell below 30). So, it is quite possible that we will be testing resistance once again. As I have stated in earlier posts, to determine whether resistance is likely to hold, it is necessary to evaluate what would drive profit expectations to higher levels so that resistance would be broken? Again, check the economic calendar for the upcoming week or two.

Let me finish this post by showing another way to determine likely levels of support should the market fall in coming days. This is illustrated using Fibonacci Analysis. In StockCharts.com, when you choose "Annotation," there is an icon to do this. Go from the most recent low to the recent high. The result is illustrated below (click to enlarge).

To add Fibonacci Analysis, click on the button highlighted in the upper portion of the above chart, then drag your mouse from the low value to the high (hold the mouse button until you reach the final level).

According to Fibonacci Analysis, the first likely level of support from an uptrend "retraces" 38.2% of that uptrend (this is called a Fibonacci Retracement). If that level of support fails, the next likely support occurs at 50% retracement. Finally, the last support level is at 61.8% retracement. If the market falls below 61.8% retracement, it is fairly likely that the prior low will be tested. Consult the RSI to assist you in deciding (in real time) if this is likely to occur.

Dow Jones Fails at Resistance

The Dow Jones Industrial Average (DJIA) recently tested then failed at resistance (of 11,258). There were signs in advance that this might happen. First, the index was very overbought, as the RSI (for nine periods) was far above the typical overbought reading of 70. Second, there was an intermarket relationship at work -- the US dollar found support. For quite some time now, the stock market and the US dollar have moved in opposite directions (the result of the dollar carry trade). The chart below (click to enlarge) shows this recent price action in the DJIA. The line below the DJIA chart is that of the US Dollar Index. Note how it turned up at support just as the DJIA failed at resistance.

Where will the market go from here? Translating this to technical analysis, where is the next support level? From the chart, the next support occurs at 11,100. The second (next) support level after that is at 10,900.

There is another element in this situation that needs to be examined, however. While the overall market has recently pulled back, does this mean the uptrend has now ended? The definition of an uptrend is not, as might sometimes be thought, continual increases in price. Instead, an uptrend is a series of higher highs and higher lows in price. At present, the DJIA is still in an uptrend. There is another way to help determine this. Using the RSI, an uptrend exists as long as RSI(9) > 40. While typically, a bullish signal is an RSI at or above 50, many persons (including myself) use support for a trend at the RSI of 40. In other words, as long as the RSI(9) remains at or above 40, view the uptrend in the DJIA will still be in tact.

So, will the uptrend remain in tact? Remember that in general, stock prices depend on interest rates and profit expectations. The primary driver at present is profit expectations. So, the question shifts to how profit expectations will behave in the near term. To answer this, it is necessary to consider monetary policy and QE2, whether US fiscal policy will shift to being contractionary, what other central banks are doing and will do, and how much strength other economies will be able to sustain. A critical factor in this is the strength of the Chinese economy. This is obviously related to whether China will further tighten its credit. A possible slowing of Chinese growth was behind today's (Friday) pullback.

To end this post, look at profits, the difference between revenues and costs. As the US dollar has been weakening, which has pushed commodity prices higher, this will raise production costs, working against future profits. What about revenues? If the economy begins to grow more rapidly and consumer spending continues to strengthen, then revenues may well continue to move in the right direction. But will this be enough to offset the effects of commodity-based cost increases? This is the question that everyone will be attempting to answer in the coming weeks.

Is the Bottom Here?

Yesterday (Thursday, 11/13) after class the markets tested their October lows. The response by the market was substantial -- SUPPORT HELD!! When the Dow-Jones Industrial Average (DJIA) broke below the 8,000 mark, a great deal of buying occurred (amazing how many persons are now technical analysts!!!), pushing the price up over 500 points for the day.

What we witnessed yesterday, was a technical formation -- a key reversal day, which technically speaking, is a reversal pattern. In the context of a downtrend (it's safe to call our situation that), here's what a key reversal day entails:
(1) the market opens below the prior day's close;
(2) prices that day go below the low for the previous day;
(3) that day's high is above the prior day's high; and
(4) the close for that day is higher than the high of the prior day.

The daily chart below shows this (click to enlarge). Importantly, the key reversal day occurred with very high volume (conviction by buyers).

The media took this as the bottom being here, attributing the turn to President Bush's speech. Sadly, both hypotheses are wrong. Although the turnaround occurred as President Bush was speaking, the substance of his speech had been known for several hours, so his speech was a correlation but not causation. Actually, what we saw was a "major league" oversold bounce which then brought about a great deal of short covering.

How can we try to decide if yesterday was "the" bottom? Look at the weekly chart, which is given below (click to enlarge). Note the triangle formation from late September to now. On a weekly basis, the rally yesterday (and all of this week's price action) has failed to challenge the upper resistance line. While the low of yesterday (also the low for the week) did entail a breakdown from the lower support line, as of the time I am writing this, the value of the DJIA snuck back above support. Also, volume is not particularly large this week.

How will the week close? ALWAYS pay attention to Friday's close (and the weekly bar). It is highly likely that this week will not be a key reversal week. That would require a weekly high above last week's high of around 9,500, etc. As a rule: WEEKLY SIGNALS ARE MORE SIGNIFICANT THAN DAILY SIGNALS. Obviously, monthly signals trump both weekly and daily signals as well. So, we need further data to confirm whether (and when) a weekly key reversal will occur.

How might we try to answer that question? Economic theory -- specifically intermediate macroeconomics. What a coincidence, that's the subject of our course! The reversal will require better-than-expected news on different parts of the global economy that imply the worst of the global recession is now able to be visualized. As stock markets are leading economic indicators, remember the stock market will turn up before the economy does. How much before the economy turns cannot be known in advance. Don't pay attention to specific values such as 6 months. Start with the key drivers of stock prices: interest rates and profit expectations, and forecast what they will likely do in the next 3-12 months. Here's a video that attempts to address the question. Remember to critique this and anything else in the media.