A Bullish Divergence for the Dow-Jones

The Dow-Jones average has remained range bound over the past few weeks. In spite of this, it is possible to see two things using technical analysis.

First, support has held after two tests. That's important, since it indicates that the negative news, etc. that drove the market lower both times was eventually overcome. Second, during this period a bullish divergence emerged, which is typically a leading indicator for the market moving higher, which it did after last Friday.

All of this can be seen on the chart below (click to enlarge):

Over the August to October period, the market was range bound, bouncing off support around 10,600. The RSI, which is a momentum indicator, showed that momentum was building, in spite of the return to support. That combination is, of course, a bullish divergence. Often, but not always, this will lead to rising prices for that market.

Let me conclude by stating the importance of the bullish divergence: it ended the possibility that the head and shoulders pattern had been formoing would turn into a significant reversal. So, FOR NOW at least, the market will likely move higher, fueled by the hope that the Eurozone will come up with a viable and systematic plan to end their problems. Remember the saying: buy on the rumor, sell on the news. So, no matter what the Eurozone eventually comes up with, there will likely be some sell off when that plan is released.

Gold Breaks $1,000

Friday was a roller coaster day for the stock market. The Dow-Jones, down by over 200 points in the early afternoon, finished "only" down 100 points, as the Obama administration assured a nervous market that nationalization of banks was not imminent (apparently, many thought this weekend could have ended with a surprise not unlike we saw at the end of last year -- this time nationalization of both Citigroup and Bank of America). You can read about this.

While the stock market was gyrating, gold rose to over $1,000/ounce (click here for story). While that is not far from the record in nominal terms, it was very far from the all-time record in real terms (around $2,200 in 2008 dollars). The move to gold was a flight to safety, not unlike what we often see for bonds (review Supply and Demand notes). Globally, markets are unsure about how long and severe this recession will be. So, rotate from stocks to bonds (interest rates fell Friday) and gold. Part of what underlies this uncertainty can be seen all too vividly with the following graph:

Gains that accumulated over five years have been wiped out over the last year and a half! We have now broken below support from 2002. Look closely at the most recent two price bars and the information they contain.

Where do we go from here? The only good news in the chart is that the RSI is giving an extremely oversold reading (of around 10). So, based on the way markets usually work, we are due for an oversold bounce. But other things are not equal. So, when might the bounce occur?

This is where you need to add economics to model the Dow-Jones average. Recall, the two primary factors moving it are interest rates and profit expectations. Interest rates for now are not a concern, so focus primarily on profit expectations. Predicting them necessarily requires a forecast of credit availability and financial system workings (read this intriguing article). Because this is so uncertain at present, opinions change every day. As market participants continue to change their minds often, they move in and out of different assets and stock sectors, causing volatile stock prices (referred to as the repricing of risk).

Expect this to continue until markets see a predictable (not necessarily effective) direction for financial markets, housing prices, and overall economic activity. ALL THREE ARE ENDOGENOUS AND SIMULTANEOUSLY DETERMINED.

Big Drop in the Dow-Jones

This past week saw notable movements in the Dow-Jones Industrial Average ($INDU). We discussed much of this in class (thru Thursday anyway). Friday was not a good day. The DJIA closed down 120 additional points, ending at just over 12,100.

The DJIA has been in an uptrend for many months now (since August 2006), so some sort of correction was called for. Typically, these corrections range between 5 and 10 percent declines. The time frame is variable -- there is not a "typical" correction period. IF, however, a correction ultimately involves a 20% decline, the market is deemed to have changed to a "bear market."

After a week like the one we just went through, I recommend using weekly charts to view trends, etc. The chart shows $INDU weekly (click to enlarge it).

One thing to note: just as there is support for price in a main chart, you can use levels of the RSI to denote whether a trend remains in force. As you can see in the diagram, the uptrend remained in tact as long as the RSI (based on 9 periods) stayed at or above 50 (the demarcation point). Since July of 2006, until this past week, that condition was met.

Look at the large weekly bar, which closed near the low for the week. Not good!! Further note that this large drop occurred on large volume. Also not good!!

There is something that is visible on a weekly chart of $INDU that is not apparent from daily data: a bearish divergence. While $INDU was making higher highs since October of 2006, these were not confirmed by the RSI moving continually higher. Thus the bearish divergence.

Support appears to be around 12,000 (look at the chart). If we fall below this, things will get very interesting. How likely is it that we will move below 12,000? Fairly likely, since even after the horrible week, the RSI is not yet in oversold territory. Ugh! Stay tuned, let's see how this week plays out.

In situations like this, you should look to see if any major (i.e., potentially market moving) economic data will be released this week. The answer is yes -- the labor market numbers for January will be released this Friday. What kind of employment report would lead to further price declines? Increases? Also, don't forget about the bond market.

RSI as leading indicator

While macro courses always refer to a traditional set of variables as being the only leading economic indicators considered, one of which is the stock market, we recently saw a leading indicator of the stock market. The $INDU chart shows the recent daily behavior of the Dow-Jones Industrial Average. Notice that a declining RSI that was occurring as the DJIA attained a higher peak. This BEARISH DIVERGENCE is a leading indicator of future stock price declines.

Fed Rate Hike

Just as the Fed raised the federal funds rate by another 25 basis points Tuesday (3/22), to 2.75 percent, the stock and bond markets adjusted abruptly. Clearly, the change in wording indicated of the Fed's statement (http://www.federalreserve.gov/boarddocs/press/monetary/2005/20050322/ ) showed a greater concern about inflation (something we had already noted in class). The following day (today), the CPI release showed higher inflation than what was expected. This time, however, the stock and bond markets did not react as they did the previous day. The Dow-Jones average closed around 10,450, the Euro closed at $1.30, down from $1.34 just a few days ago, and the 10-year bond rate was almost unchanged from yesterday (at 4.61%).

For those familiar with candlestick charting, today's market activity formed a "shooting star," which occurred at a resistance level, when the RSI was in overbought territory. From a technical perspective, this set of occurrences points to the likelihood that the 10-year rate may be resting at its current level in the short-term.

Only a few days ago, the Dow-Jones tested resistance at 11,000. That seems like a long time ago, even though it was a short-time ago.

Finally, oil prices dropped sharply again today. Had this not occurred, would the decline in the Dow-Jones been as small?