Which Way Will the Market Go?

The recent rally has taken a pause at best, and perhaps the recent rally has run its course. While the market has declined for the past two days, today's decline was much larger than Monday, as the S&P fell by almost 20 points back to 815.6. How can we gauge whether this is the end of a rally or merely a pause in an uptrend?

Technical indicators are helpful for this. The following chart (click to enlarge) is the daily S&P performance over the past six months. There are two conflicting signals in this chart. First, note the performance of the RSI. While the S&P has recently risen sharply, that momentum was not confirmed by the RSI (see the lines in the chart). Recall, this is a bearish divergence. But if we work with moving averages, we get a buy signal. In the chart I have added the 20-day and 50-day moving averages. Notice that in the past few days, the 20-day has crossed above the 50-day moving average. This could potentially be considered a buy signal (recall: this is related to the average-marginal relationship we discussed earlier in the semester).

So, which indicator should we rely on? Since moving averages are lagging indicators and a bearish divergence of the RSI is a leading indicator, I would tend to go with the RSI's "signal." But that is still no guarantee that the rally is over -- it merely indicates a short-term pullback is in store which we are now witnessing.

In a situation such as this, you should look at weekly data for whatever information it contains, since weekly data does not contain as much "noise" as does daily price data. The chart below shows weekly S&P data (click to enlarge). I have added the 13-week moving average since this corresponds to a quarter. Note how well this fits the price data.

The weekly RSI shows very different momentum information than does the daily chart. Note the weekly RSI is far from overbought, and there is no bearish divergence. Actually, the RSI has failed for some time to move beyond 50, which would have indicated movement to more bull-market-type momentum.

In this situation, I recommend that you view an RSI value of 50 as resistance for the S&P's price movement. So, based on the weekly RSI, this rally failed at (RSI) resistance. I would only place bets on upward continuation when (and if) the RSI is able to sustain a break above 50. Were this to happen, daily data would clearly have to show an end to the recent pullback.

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.

Dow Jones Record

The Dow-Jones Industrial Average ($INDU) set a new record today, closing at its highest level ever. You can read about today's performance or explore its history. The real question is whether this upward move has "legs." Will resistance hold, and today be part of a failed breakout, or will we move toward even higher levels?

Applying technical analysis, there is reason to think that today's record will be met with a pullback in the near term, even though the RSI doesn't indicate that $INDU is oversold (based on the weekly data used). The chart below (click to enlarge) illustrates that the record -- as resistance from early 2000 -- was broken today. Why do I think some pullback is coming? Using the RSI, there is a bearish divergence: the $INDU has moved higher (it has higher highs) but this has not been confirmed by the RSI (it has lower highs).

Where will the Dow-Jones go from here? To answer that question, economics is needed (see the prior post for an example of this).

stock prices = f(expected profit, interest rates)

Put these together and you get the present discounted value of expected future profits. Here are the types of questions that must be answered to arrive at an answer (which, bye the way, is a forecast):

(1) Has the Fed finished raising interest rates?
Will they actually lower rates next year (as the bond market presumes), or will inflation remain in the problematic range?
(2) Today, oil prices fell below $59/barrel. Will this continue? If so, this will moderate inflationary expectations and the inflation premium in nominal interest rates). What about declining gasoline prices? This will help consumers, but with a lag (it takes time to replenish the spending power lost over all these months with $3+ gasoline prices.
(3) How much damage to economic growth will be done by housing sector weakness? Have declining interest rates placed a bottom on the decline in housing, or is there quite a ways (down) to go yet? Look at a few home builder stocks. These appear to have bottomed. Is that a leading indicator of what is to come for the housing sector? Business construction (in the GDP accounts) have begun to rise. Will this be able to offset home construction weakness?
(4) Consumer debt has piled up -- largely through the use of home equity. What will power spending in the next several quarters if home equity can't? Job growth and income gains are critical here.
(5) Will business spending (Equipment and Software) be able to pick up the slack from weaker growth (or actual declines) in consumer spending? Judging from the most recent quarter's GDP report, no. But was the decline in this category an anomaly?
(6) Will growth in Europe continue to pick up and that of Asia remain strong? If so, this bodes well for export growth and profits to firms that have international sales.

This is not necessarily the entire list. But for a forecast of stock prices, like any forecast, you must identify what the relevant factors will be in the next 6 months or year, predict what each of these will do, then put all of this together to arrive at a conclusion.

Bearish Divergence As A Leading Indicator of Price Change

Cyclical stocks ($CYC) move in the same direction as actual or expected economic growth. As a market, this is itself a leading indicator. And, its changes contain real-time information on market expectations concerning growth.

As you know, yesterday (9/21), two indicators were released that caused markets to change sentiment -- reflecting the belief that the economy would weaken farther and possibly faster than was previously expected. On yesterday's blog post, I detailed how this affected the 10-year bond rate. That rate fell again today (to 4.6%). With the expectation of slower growth, cyclicals should also weaken. And they did.

In the handouts on technical analysis, I detailed what is called a bearish divergence: price action moving higher but the RSI not experiencing higher highs. This is a leading indicator of a downward move in price in the near term. Note this is not 100% accurate, but it has a fairly good track record.

I have included a graph of cyclical stocks where such a bearish divergence is evident (and marked). Click on the chart to enlarge it.


Based on this bearish divergence, one should have expected some decline in cyclicals, and thus the perception of a weakening economy gaining traction. THIS DOESN'T MEAN THE ACTUAL ECONOMY WILL NECESSARILY WEAKEN -- JUST THAT THE EXPECTATION OF THE MARKET IS THAT IT WILL WEAKEN.

To earn extra credit, get the chart of cyclicals and using weekly data for the past two years, annotate the chart, drawing lines and adding comments. Determine if a bearish divergence occurred. Also, draw the support line for weekly data and a possible support line for the Relative Strength indicator. This will be accepted no later than the beginning of class on Monday. No pencil or pen lines will count.

The next test is to see if the support line (indicated in the graph) is broken next week. Note that cyclicals have been underperforming the overall market (based on a declining Relative Strength (below the graph) since early May. It is also possible to draw a support line for the Relative Strength indicator.