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.

Bond Market

Today we discussed the bond market in class and how bond prices and interest rates move in opposite directions. This can be seen vividly in today's news. Existing (median) home prices declined relative to last year, a rare event. This is bullish for bonds since it implies that inflation should come down a bit, and the inflation measures we use (like the CPI) will likely drop as well. Remember: bullish for the bond market means higher demand and higher bond prices -- which causes lower interest rates. You can read about this in an article from MarketWatch.com.

To further understand what is happening, remember our basic model of nominal interest rates (r):

r = f(expected inflation, economic growth, monetary policy)

Today, the news caused expected inflation (and actually expected growth) to moderate, causing nominal interest rates to fall. Remember: you can also explore this by using the ratio TIP:TLT in StockCharts.com, or take a look at the TIPS spread from Bloomberg.com (the link is: http://www.bloomberg.com/markets/rates/index.html ). You should bookmark this link.

When at Bloomberg.com above, page down to the graph. This is today's yield curve. Then, click on the tabs for different countries. Compare the interest rates (say 10 year) for the different countries listed.

Finally, oil prices bounced off support at $60 today. Graph $WTIC in StockCharts.com. Look to the left from today's values to see where support lies. You will see a $60 support point from early March of this year. Had this support not held, the prior support of just under $58 that I mentionned in class would be the relevant level. There was a bullish divergence in effect which makes today's move not entirely surprising. Oil price was falling while the RSI was making higher lows.

The question now is how long this upward move will hold. How far might it go? Resistance, remember?