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.

Golden Cross in the Dow-Jones Industrial Average

Something fairly rare has occurred in the Dow-Jones Industrial Average (DJIA) over the past few days: the 50-day moving average crossed above the 200-day moving average. This is referred to as a "Golden Cross." The chart below shows this (click to enlarge):

To many, this signifies a major buy signal for the stock market. Indeed, if you look at history, when this occurs, generally the market does fairly well for the next several months. Is that likely to be the case this time?

Over the past few years, the stock market has allowed patterns such as this to emerge. But, instead of potential investors being patient and waiting for further confirmation before entering the market or expanding their positions, they have all too often jumped in enthusiastically. What has the market done? It has caused the pattern to either reverse of be eliminated, stranding those poor (now literally) souls who impatiently dove into the market and committed their funds.

This happened about a year ago, when a head and shoulders pattern formed in the S&P 500. Before waiting for confirmation (price must fall below the "neckline"), it seems that just about everyone jumped in to short the market or obtain options that work the same way (puts). When the pattern failed to materialize, many were caught on the wrong side of the market (short the market). In a panic, there was an attempt at a mass reversal of direction, leading to a major rally for several months!

Let's get back to the chart. Yes, there has been a Golden Cross. BUT, note that the DJIA is in slightly overbought territory (i.e., the RSI > 70) AND at its current level, the market is not far from a resistance level. Put this all together and it is not clear that the Golden Cross will be sustained in the short-term. If resistance holds, those who have recently jumped into the market will not be happy.

Now let's shift gears and inject economics into this. In addition to the technical analysis I just covered to evaluate whether the DJIA is likely to go above resistance, use economic theory:

DJIA = f(short-term interest rates, profit expectations)

(this was covered in the most recent set of notes). Short-term rates, related to asset substitution, are likely to fall a bit more, but they are already very low. So, don't expect much change from this component. Focus instead on profit expectations.

For the DJIA to break above resistance, it is necessary for profit expectations to be elevated above their current levels. QE2 (possible upcoming quantitative easing) has already been priced in. So, if that fails to materialize, stock prices will fall and much of this last leg up will likely be lost. Earnings results are beginning to be reported. If those are very good, better than expected, resistance may well be broken, as long as two things occur. First, top line (revenue) growth has to be emerging with greater regularity than it has in the past. Second, earnings guidance (what they expect to occur in future quarters) cannot be disappointing.

Then there is the election. The stock market will very likely react positively to the expected increase in the number of Republicans in the House and Senate. But I expect this to only be a short-term rally. Gridlock will occur, as governing will more closely resemble the WWE than what we studied in Civics class. Historically, gridlock favors bonds over stocks. Beyond this, the desire to move toward smaller budget deficits will hinder economic momentum over the short-term.

So, at this point, it will be interesting to see how all of this plays out. I do expect a short-term rally after the election, before the market returns to fundamentals as next year begins. While it is quite possible that the Golden Cross will hold for a few months, I expect this to be a shorter period of positive upward momentum that prior crosses have produced.

What are Interest Rates Telling Us?

As we outlined in class yesterday, interest rates and the bond market have a great deal of predictive ability concerning future levels of economic activity. The simple yet very powerful model of interest rates you should use is:

interest rate = f(expected inflation, economic growth, monetary policy)

As I noted, inflation expectations and growth expectations are not necessarily independent of each other, so the time frame you are considering becomes relevant to seeing which matters more. You can use the TIP:TLT ratio in StockCharts.com as one proxy for expected inflation, while a preferable way is to calculate (and track through time) the TIPS spread (= nominal interest rate - TIP rate with same maturity). This is available daily (in real time) from Bloomberg.com. Here is a link to the web page to use for this. As of today (4/21/10), the 10-year US Treasury bond has a rate of 3.79%, while the 10-year Inflation Indexed Security (TIP) has a rate of 1.43%. So:

TIPS SPREAD = 3.79% - 1.43% = 2.36%

Historical data on this is available from the Federal Reserve Economic Data (FRED).

If you want to find a proxy for the level of economic activity and income, you can use consumer cyclicals ($CYC) in Stockcharts.com. Where is support for this? Resistance? Are there any leading indicators from technical analysis that can be of help in the short-term (ex: bullish or bearish divergences based on the RSI)? 

So, you should use the interest rate model above whenever you need to explain interest rate changes or to make interest rate forecasts. To do this, you will need to generate a forecast for each explanatory factor. Possibly, over the time period of your forecast, a factor that usually matters will not matter much. Or possibly, a factor that normally doesn't matter much will be influential. Remember: NOBODY KNOWS THE FUTURE (except CNBC, of course).

For those of you who have taken ECN 327 with me, you can expand the basic interest rate model substantially. Using general macroeconomic models such as the IS-LM and AD-AS, you can identify a fairly large set of factors that determine either economic growth (Ye in those models) or inflation (changes in Pe in the AD-AS model). Basically, those factors are the "other things" of the relevant curves.

Looking at a chart (click to enlarge) of the 10-year rate ($TNX), resistance at 4% becomes readily apparent (note: you must divide the number on the right axis by 10 to get the interest rate). Short-term support is at roughly 3.5%. Why has resistance held over the one-year period covered by this graph? Rates fell twice from 4% (a double top, by the way). What causes interest rates to decline? To answer this question, use the interest rate model.

Rates decline for some combination of declining expected inflation, less expected future growth, or monetary easing. Obviously, we can rule out monetary easing. That leaves us with declines in expected growth and inflation.

Will the 10-year re-test resistance or support? Again, use the interest rate model to answer this question. Anyone doing their forecast on interest rates will have to do this.

Read the relevant chapters in John Murphy's Intermarket Analysis to further help you with an understanding of this topic.

February's Employment Report

February's employment report was better than expected. Even though there was a loss of 36,000 jobs, weather factors had been fully expected to exacerbate the final number. More importantly, when weather-distorted values of employment such as February occur, the jobs number in the following month almost always shows a significant rise, as some of the weather-related loss is "made up." This is clearly the expectation going forward, that March will show a rise in employment (not just because of the addition of Census workers). The unemployment rate remained at 9.7 percent, also better than anticipated, leading some to conjecture that we have already. Gseen the peak unemployment rate (I am not convinced of this yet). Here is an article about the report, and two videos from CNBC about the employment report. The first is pre-report, the second occurred after the data were released. The bond market hated the employment news, selling off, as the 10-year bond rose 8 basis points (remember: when bond prices fall, interest rates rise).

Most of the time, when an employment number is released, the stock market tends to bounce around, as bulls and bears battle throughout the day. Generally, this leads to a small daily change for the market that day. This was not the case on Friday, as the market shot higher and sustained its momentum throughout the trading day. The result was a large candle, a large real body, and almost no shadow (tails). Here is the chart for Friday (click to enlarge). Note that resistance in terms of the RSI(9) remains above 60, but it is now slightly overbought. So, will we make it to the next resistance at 1150 without a short-term pullback? Check next week's economic releases and see if there are any major releases that can materially affect the stock market.

 I believe that the stock market sustained its earlier momentum as the day wore on because in addition to the jobs report, there was a report that consumer credit had risen, painting a potential picture of how a recovery will gain traction. Of course, time will tell if that perception turns out to be correct, but I believe the market is pricing this in.

There was a good video on CNBC that discusses sectors (a bit) and the interest rate to look at (2-year US Treasury) as a signal that the market will break out from its recent sideways action.

Finally, I didn't mention it in class Thursday, since I want to see who reads the blog postings, but our exam will be on Tuesday, March 16. So, dig in, do the assignment, and study for the upcoming exam.

Three Different Resistance Measures

The S&P 500 has stalled around its 50-day moving average, as was true the other day (see the previous post). Now that a few more days have passed since then, we saw a couple of spinning tops, which indicate indecision, then a large down day (yesterday) followed by a significant up day (today). Today's bullish candlestick was not as large as yesterday's bearish candle, and today the market opened from a higher level than yesterday's close. In OHLC charting, this is referred to as an inside day. Overall, I think it is safe to say that there is no definitive direction for future price change at this time. As I stated in class, at times like this, it is advisable to consult the economic calendar for the remainder of this week and next week, identify the "biggie" releases that will occur, then attempt to determine what each of these will do and how the market will react. Nobody can know this with certainty, so don't be intimidated. Actually, if you listen to the "talking heads" on the financial stations and keep track of what they predict, you'll probably be surprised by how inaccurate these persons are. So, don't be afraid to venture out and try this, you probably won't do any worse than the "talking heads."

Look at the following charts and analyze the most recent candlesticks and think about what they indicate about the battle between bulls and bears. Using these, I will now present three different ways to measure resistance.

#1: Fibonacci Retracement: If we apply a Fibonacci Retracement to the most recent high and low of the daily S&P 500 (see chart, click to enlarge), we see something quite interesting: the recent rally stalled at the 61.8% retracement point. The use of Fibonacci Retracement suggests that after a decline, the first possible point of resistance in a rally is when 38.2% of that rally has been erased (retraced). The next possible resistance point is at 50%, while the last occurs at 61.8% retracement.

#2: 50-day Moving Average: The next charts (click to enlarge) shows that the 50-day moving average acted as support for the S&P 500 since last fall, then became resistance in late January of this year. It is fairly common for prior support to become resistance (and vice versa). Note how the most recent rally failed just at the 50-day moving average. At this point, based on the most recent candlesticks, the direction of future price is still a toss up. A definitive move above the 50-day moving average, especially for a major market index, would be very bullish, and we might have a shot at returning to the previous high. If that were to occur, then the market falls below that level, what technical formation do we have? A double top, which is a reversal pattern. More about establishing a down target later this semester if this possibility occurs.

#3: RSI(9) < 60. In this same chart, look at the RSI in the upper portion. Note how the most recent high coincided with the RSI falling below 60 and remaining there. Just as the S&P is now testing its 50-day moving average, so too is it testing the RSI at 60.Often, an RSI value of 60 is used as resistance for a downtrend, while 40 is used to designate support for an uptrend.

So, what will happen from here? As I stated above, look at the economic calendar, identify the "biggie" numbers that can potentially move the market, and attempt to predict what each of these will do. In doing this, you are actually using economic theory, which states (for our purposes at this point):

      Stock Prices = f(interest rates, expected future profit)

In analyzing the future releases, focus primarily on the macroeconomic implications for profit expectations, since Fed Chair Bernanke indicated again today that the fed funds rate will remain low "for the foreseeable future." That reassurance was a fundamental driver of today's rally which erased most of yesterday's losses.

Surprise Discount Rate Announcment

Yesterday, after the markets closed, the Fed announced that it was raising the discount rate by 25 bp. Here is a story about this. The initial reaction after hours was as expected -- the announcement took everyone by surprise. Before this morning's market open, futures pointed to a down day, although the amount kept shrinking. What all of this points to is uncertainty and indecision as market participants digested all of this and formulated their views of the likely consequences.

Which types of candlestick bars depict this? Forget a candle with a long real body and little in terms of shadows (i.e., tails). Look over the candlesticks I covered the other day in class. One would expect either a doji or a spinning top. What actually occurred for the S&P 500 was a spinning top. Here is a chart of the current data (click to enlarge) as of the Friday close.

The RSI is not yet overbought, so potentially there is room for further upward price movement. Note that the RSI is approximately 60, which is the value that some use to indicate resistance for a time of weak price movement. The most striking thing in this chart is the fact that the $SPX closed above its 50-day MA for the first time since January of this  year. If the market were worried about the impact of the Fed raising the discount rate, would the S&P have closed above its 50-day MA today? No, it would not have. So, today's price action, in spite of signaling indecision in terms of a spinning top, does allow for the possibility that it the S&P will remain above its 50-day MA at least for the very near term. The real question is whether former resistance, in terms of the 50-day MA, will now become support.

How can we arrive at a way to answer this question? Using economic theory, we model stock prices. According to economic theory:

                    Stock Price = f(interest rates, expected profits)

Interest rates pertain to asset substitution possibilities in the short-term (review the stock and bond info in the Supply and Demand notes) and product demand in the medium term. Were yesterday's surprise discount rate announcement taken to indicate that Fed tightening was about to begin, not only would the market have failed to clear the 50-day MA today, there would likely have been a noticeable upper shadow (tail) as well. Also, there was a CPI data report today that signaled benign inflation, which signals that interest rates should not rise much.  So, the primary factor to focus on is profit expectations. For extra credit, due at the beginning of class on Tuesday, plot the relative strength of the S&P 500 (a measure of stocks) compared to TLT, a measure of longer-term bond prices using as a chart type a solid line with weekly data. In a short word document, include the chart with annotations from StockCharts.com (not hand written) and a very short discussion of what the relative strength of stocks vs bonds is showing us about expectations for future economic activity (and therefore profits). Feel free to consult John Murphy's text about this.

When you get a chance, you should read two excellent columns on technical analysis by Michael Kahn in Barron's Online. I strongly suggest that you save these and others throughout this semester (and beyond). The first of these, written in early February, talks about the market correction. Follow his reading of candlestick charts and overall analysis. The second, from this past week, analyzes the question of whether the market will be fighting back and trend up.

November Employment Report

The November employment brought with it several surprises. First, and foremost, payroll employment fell by far less than just about anyone (including me) had predicted. While the consensus number was a decline of around 120,000, the actual number was a decline of just 11,000. In addition to this, decreases from the prior two months were revised to show less job loss. So, with the addition of Census workers early next year, it is very likely that we will see the employment change go positive -- either next month when the November data are revised or when we get January or February data.  Second, there was a nostalgic element to Friday's action in that the stock market actually rose along with the US dollar. When was the last time that happened? You should read about the employment report from MarketWatch.com and the Wall Street Journal.

The stock market liked the employment report very much. The Dow-Jones Average started out showing a gain of around 150, but as is so typical of employment release days, gave most of that back (this apparently works in both directions). At the end of the day, the Dow was up 23 points (for 0.2%). Interestingly, the NASDAQ was up by a greater percentage than the Dow, as its 21 point gain was almost 1 percent. Typically, when observing markets it is a good sign when the NASDAQ outperforms the Dow-Jones average. As this stock market "rally" was occurring, the bond market obviously hated what it saw, so a selloff resulted. As bond prices fell, the 10-year bond rate rose by a full 10 bp, a rather significant change. The US Dollar index rose by just over one point (1.07) to close at 75.8. So, enjoy this combination while you can -- a bullish report triggered stock market gains, a bond market sell off, a stronger US Dollar, and a drop in Gold price. That is the way things normally go, but haven't gone this semester as the result of the dollar carry trade.

Along with this favorable economic report, of course, comes all the myopic garbage that has come to characterize coverage by the financial media. Will the Fed now begin to raise rates very soon based on the new-found economic strength? Give me a break! Is the carry trade dead, based on Friday? Gee, we have one full day of that result, so it must be inevitable! I'll probably reserve judgment, though, until I hear from Jon and Kate, and check in with Tiger Woods. Here is the URL for an article with an intelligent discussion of the likelihood of Fed actions based on Friday's report.

The interesting question is how long the pattern of the inverse relationship between the dollar and US stock market has existed. It must seem to all of you that this has been around for a very long time, that this is the "norm." For extra credit due at the beginning of class on Tuesday, produce a chart using weekly data going back three years with the Dow-Jones average and the US Dollar index in the same chart, both as solid lines. Adding annotations, eliminating other elements of the graph like MA's, pinpoint when the current pattern began based on this chart.

So the question now becomes whether the dollar carry trade is dead or possibly dormant for a while. If this is conjecture turns out to be true, the US Dollar should begin to rally without threatening the positive momentum of the US stock market. We can use technical analysis along with economic theory to ascertain whether any short-term bottoming of the dollar is in the cards. Based on the RSI(9) from weekly data, there was a bullish divergence for $USD -- the RSI had been rising while the weekly $USD was recently falling. So, in the very short-term at least, some dollar strength is likely, especially since the RSI is nowhere near an overbought level. In fact, the weekly RSI(9) is at 40.5, which if you look back several months to April, is a resistance level for the RSI. If that resistance is broken, the dollar index could go to either 77 (its next resistance point  determined the usual way) or all the way to 80 based on a Fibbonnacci Retracement from March of 2009 until the most recent low. Stay tuned!

10-Year Bond Rates

If you look at the 10-year bond rate since the end of 2008, the economic free fall, until the present time, you see several interesting and informative behaviors. First, when the economy was in potentially serious condition in November and December of 2008, rates gapped down on several occasions. This means that bond price gapped up on those occasions. Second, if we apply Fibonacci analysis to the bottom in rates at the end of 2008 up to the present time, you see that Fibonacci has been very predictive for likely declines from the recent 10-year peak of around 4% in June of this year. The chart below shows this (click to enlarge). Remember that the values on the right axis are 10x the interest rate, so 36 is really 3.6.

The 61.8% retracement level (around 3.27%) has been touched on several occasions. Note that the rate has yet to fall to the 50% retracement point (at 3.04%). While we remain slightly above the 61.8 percent mark, note that the RSI is still above the oversold reading of 30, so it is quite possible that we will see another retest of the 61.8 percent level at 3.27%. The likelihood of this rests on, among other things, markets continuing to believe the message delivered by Fed Chair Bernanke the other day.

What we have been witnessing in the short-term, however, is a rising stock market with a strong bond market. So, stock prices have been rising while interest rates have been falling. This is not the typical pattern. Usually stock prices and interest rates move in the same direction. You should think about this to strengthen your understanding of the stock and bond markets. The "other thing" that is not equal is the words of the Fed Chair.

I have recently heard some "talking heads" discuss whether the bond market is a bubble at present, while others are hinting that rates have gotten very high, potentially a cause for worry. I have plotted the 10-year rate weekly over a very long time period. The chart shows this from the early 1990s (click to enlarge). The current 10-year rate is hardly excessive based on its history, which showed it to be around 8 percent in the early 1990s. Note the long-term downward sloping resistance line. Were we to move up to that line, the 10-year rate would have to rise to 4.75 percent, which is approximately the level it attained during the double top in 2006-2007 (note: that double top is what converted me to using technical analysis -- the technical analysis prediction of a declining rate from that double top ran counter to the "traditional economic wisdom" of the day which saw higher rates coming). How likely is it for the 10-year rate to rest resistance at around 4.75 percent? Use the model of interest rates we have developed and enhanced from class:

r = f(expected inflation, autonomous spending components, monetary policy)

Remember: in place of economic growth in this model, you should now employ the Basic Keynesian Model which identifies factors that generate growth: changes in autonomous spending (from C, Ip, G, and NX). The resulting forecast will allow you to move well beyond the limits of technical analysis.

How Overextended is Gold?

I have been going over the market for gold ($GOLD) in class since last week. We have looked at daily and weekly data, viewed the RSI, and we have gone back to consider where the US Dollar ($USD) is, as the dollar and commodities are inversely related (other things being equal). What I want to do in this post is to show you another way to show whether something is overbought or oversold.

First, chart  $GOLD using daily data. Find a moving average that fits the time period under consideration very well. After a number of different values (starting from 20-day to higher periods), I found that the 150-day simple moving average fits gold very well, as the chart shows (click to enlarge).

To find a way to view how far the closing price is from this moving average, under "Indicators" below the graph, use the following information with StockCharts.com: MACD with values 1,150,1 (select MACD then enter the values I indicated).

That produces the graph below the Gold chart. You can annotate any (or all) of this set of charts. Here, apply a horizontal line to the peaks of the gap measure (the MACD values) to find where resistance has been before. It should be clear from the chart that recently, Gold price moved above its 150-day moving average by the greatest amount since either June of 2008 or September of this year. Note, also, this has occurred as Gold is very overbought based on the RSI (which is also showing a bearish divergence).So, you can see from this chart that there is yet another basis to conclude that some short-term pullback in Gold price is likely. Note, though, that markets can remain overbought for some time, so any pullback might not occur for a while yet.

Friday's Employment Report

I had stated in class that the bond market anticipated a bad employment report. THE BOND MARKET WAS CORRECT. In anticipation of a larger-than-expected fall in employment (an actual fall of 263,000 -- much worse than the "consensus" estimate), and thus slower growth ahead, interest rates had been falling during this week. And, the actual number didn't do anything to reverse that trend. Here is a very short summary of the day's 10-year bond performance.


The chart (click to enlarge) shows the ten-year bond rate ($TNX). NOTE: the rate of interest is the listed value on the right axis divided by 10. So, 35 corresponds to a 3.5% rate, etc.  Resistance for the 10-year bond rate has recently been 3.5% -- you can see the rate bouncing off this level several times since August. Focusing only on this past week, we see a noticeable decline in the 10-year rate, in anticipation of a weak employment report.

As interest rates and bond prices are inversely related, note from the RSI indicator above the chart that rates are oversold, so a bond rally (on potentially bad news) has caused bond prices to be overbought.

There is one interesting thing about Friday after the employment release: the 10-year rate rose (and prices fell). And, while the rate hit 3.1% at one point during the day, the close was higher than the open. There was also a lower tail (remember: a possible signal of change of momentum). It is quite possible that the low on Friday may be a 10-year low for the short-term based on Friday's price bar. Keep in mind, though, that mortgage rates tend to be highly correlated with the 10-year bond rate, so it appears that we are going to see lower mortgage rates ahead (below 5% on 30-year mortgages). The real question is whether mortgage applications rise or fall ("other things" are not necessarily equal).

The stock market had a rough couple of days. After class on Thursday, the market dropped sharply. Friday, after the report, another sharp drop occurred until around mid-day when we came off the lows of the day. Here is a story about the stock and bond markets. For extra credit, due at the beginning of class on Tuesday, create a chart of the S&P 500 (daily) using "fill the chart" as the data range. Put the RSI in the same chart (not above or below it), paste this into a Word document. In that document, provide a brief summary indicating how the RSI signaled the recent stock market decline.

You should continue following the bond market throughout the remainder of this semester and beyond, noting what it is forecasting and contrast this with what the stock market is assuming. We will cover the stock market this week.

Gaps and the NASDAQ

On occasion, gaps appear in price charts. These arise almost exclusively in daily and intra-day charts. There are a number of things that cause gaps to emerge in individual stocks, such as news or earnings announcements (positive or negative) coming out after a day's trading has ended, which causes a new equilibrium price that is different enough to gap up or down from the prior day's trading range. Actually, there are several different types of gaps. There is a good article about them at Chart School in StockCharts.com, and another about how to trade gaps on Investopdia.

The reason for this blog post is that the NASDAQ has seen several gaps over the past few weeks. The chart below (click to enlarge) shows this. One thing that many of us who follow the market utilize is the tendency for gaps to be filled. How long it takes for this to occur, however, can vary widely, and it depends on the type of gap (see the articles above). Some, breakaway gaps, for example, can take quite a while to fill, if they even end up being filled. At the other extreme is exhaustion gaps, which are very likely to fill (see articles). The gaps in the NASDAQ chart are merely "plain vanilla" or standard gaps. Note an interesting pattern for the last two gaps: they both filled on the third day (almost sounds biblical!). DO NOT make anything of this, it is merely a coincidence.

I do want to point out a trading strategy related to the typical gap. Since gaps tend to eventually fill (again, depending on the type), some traders will essentially place trades that presuppose this. In other words, they trade in the opposite direction of the gap. This is called fading the gap. While I have used this on a number of occasions in the past, I did so with added criteria. So, according to this trading philosophy, if a down gap emerges, go long in anticipation that price will rise and fill the gap.

How likely is it that a gap will be filled in a reasonable time period? Use technical indicators to make this determination. If there is an up gap, for example, and price moves fairly close to resistance and/or the RSI shows an overbought reading, the odds of gap filling are in your favor. It might take longer than you are comfortable with, however. This has a bearing when traders are using options which have a time decay factor that lowers their prices each day as you wait for the filling to occur. Similarly, if a gap down occurs, moving price close to support and/or the RSI is at oversold readings, the likelihood of filling the gap are fairly good. As always, identify either bullish or bearish divergences improves the odds of your being correct even more.

When I originally planned to write this blog, another pattern existed that has now ended. The most likely support for the NASDAQ at present is its 50-day moving average. If a gap emerges that is not very far from the 50-day, and the RSI is at or near an overbought reading, the odds that the gap will be filled as part of a retest of support (at the 50-day moving average) are very favorable.

Let me end this post by transcending exclusive reliance on technical criteria. If you are attempting to determine where price will eventually go, create a price forecast using economic criteria. Identify the primary explanatory variables that will influence price over your time period of interest, then predict what each of them will do. Once you have done this, determine the dominant changes and along with that, your price forecast. For the market as a whole, price depends on interest rates and profit expectations. You then find several variables for each of those factors. At the firm or industry level, the choice of factors can differ. For example, interest rates might not be very influential (ex: consumer staples), or how cyclical the firm or its industry are must be accounted for. That leads to your identifying additional factors to use in your forecast.

Hopefully, it might have crossed your mind that it is also highly useful to incorporate intermarket relationships into this type of analysis. What is the commodity market signaling? How about currencies? The bond market? Put all of this together (as you must for the course paper) and you have a very educated guess about the overall market's direction.

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.

Follow Up to January Employment Report

I hate to say I told you so (in the previous post), but the market sold off sharply yesterday (Tuesday, 2/10) when Treasury Secretary Geithner presented his plan (actually, more of a broad outline). Who was particularly hard hit? Banking and financial stocks. What the stock market did yesterday is what it would normally have done on Friday after the employment report. Note that this large market decline occurred along with a very large volume -- indicating "conviction" in this move.

Sadly, this was fairly predictable, not only based on a "buy on the rumor, sell on the news" basis, but since so many of the "talking heads" on television had been trying to convince people that this was an excellent time to get back into the market. I have even heard speculation that had (and when) sufficient details been provided for the financial package the market would rebound. Only if the package ends disease, brings peace to the world, extends global life expectancy to 100+ years! In other words, any package will be imperfect, and market participants will find reasons to be less than enthusiastic.

There are two things I want you to focus on from yesterday. First, we witnessed a textbook example of a flight to safety (review this in the Supply and Demand notes), where persons fled stocks, lowering stock prices, and moved their money to a more safe place, the fixed income (bond) market, raising bond prices and causing interest rates to fall. In fact, the US 10-year bond fell significantly, by about 16 bp yesterday. Second, the Dow-Jones average broke well below 8,000, closing at 7,888. This moves us back to levels we haven't witnessed since mid-November. Don't expect any significant positive market momentum until we get some meaningful clarity on the financial program. In other words, I believe the market will move lower before rising -- we will test further support.

How far might the market fall? Let's rephrase that: where is the next level of support for the Dow-Jones? First, check where price is relative to the 50-day moving average. We failed yet again to break the 50-day, which has to be viewed as short-term resistance at this point. Also, the RSI does not indicate an overbought condition (<30).

Look at the ten-year bond ($TNX) and see how it reacted yesterday. After peaking at 3.05% a few days ago, which had an overbought reading from the RSI, that rate has fallen sharply, yesterday and today (thus far). Also, there was a gap down yesterday. Try identifying relevant economic factors that determine the behavior of the ten-year, determine how those factors will likely be changing, then make a prediction of how the ten-year rate will be moving over the next few days.

Does This Rally Have Legs?

Friday, after a horrible employment report, the market actually rose significantly. Is the market discounting that the worst is now behind us? Or, did the terrible jobs report signal the necessity of both bailing out the "Big 3" automakers and that President-Elect Obama will have to provide an extremely large stimulus package? I think it is far more the latter. Here is a ShortView by John Authers of the Financial Times discussing the current state of the markets.

How far will the market go? In the short-term, you should always check to see where resistance is. In the chart below of the Dow-Jones average (click to enlarge), note the market ended the day just at its 50-day moving average. More importantly, it is instructive to check the Fibonacci Retracement tool I discussed in class just before Thanksgiving. This is included in the graph.

To add a Fibonacci Retracement, go to the Annotation screen (click below the image to get this). When the Java window appears, click on the Fibonacci Tool as shown in the upper portion of the graph.

Holding the left mouse key down, drag the mouse sideways and down:
(1) From the most recent significant high, to
(2) The most recent low. Once there, release the mouse key.

Note how the most likely place for a resistance point, the 38.2% retracement (the first line) is essentially where the market is now approaching. Is it likely that the Dow-Jones will reach this? Check the RSI. It is above 50 (indicating the beginning of a possible uptrend) and it is not close to being overbought. So the potential is clearly there. Also, check to see if there are any major economic statistics this week that if bad could derail this uptrend. There is nothing on the horizon like the employment report of last Friday. So, it is reasonable for the market to move past its 50-day moving average and test the 38.2% retracement at 9,164.

There may well be a "Santa Claus" rally as this year comes to an end, as the bailout (part 1) and promise of an extensive stimulus package will act like the "rumor" in the old saying buy on the rumor, sell on the news. So, early next year, there may well be some kind of correction. But, the relevant question is from what level will this correction occur? We'll have to wait until next semester.

Friday's Tumble

The stock market tumbled on Friday. The ultimate decline, 312 points, was a blessing. How? Before trading began here, markets in Asia and Europe had fallen sharply. Stock index futures for the Dow-Jones, S&P, and NASDAQ all had trading halted, as they reached limit down. Those futures were signaling an open in the US with the Dow-Jones falling as much as 1,000 points! Prior to opening, the word "crash" was being used by many (almost all, actually) market observers. I also viewed the potential for labeling the entire bear market as a crash had expectations occurred.

While the markets did drop sharply at the open, they began to recover. At times during the day, the market had moved to only "small" declines in the context of what has been happening routinely now for weeks.


The chart (click to enlarge) shows technical information about Friday, using 10-minute bars. The first thing to note is where support and resistance were. Resistance from late Thursday held all through Friday, not a very bullish sign, even though the market didn't end up at its daily low (there was a failed breakout at the end of Thursday). Look at the last bar of the day: a large bar (big range in last 10 minutes), but the close was far below the open for that time interval, also bearish going into Monday.

It is also important to consider that support held on Friday, making the overall news mixed. There was a double bottom, a reversal pattern, which signaled the rally that started around 2:00. During that time, the RSI remained above 50, signaling that an uptrend was occurring. That only changed at the close.

What were the economic factors surrounding Friday? First, there were large sell-offs in Asia and Europe. GDP for England was negative for the first time in about 15 years. That became a confirmation signal to markets that a global recession was either already in progress, or very likely. In the US, home sales actually improved. Of course, whether this is the beginning of a sustainable uptrend is a different matter. That accounted for part of the upward momentum at mid-day. Finally, one of the more important factors was the collapse of the yen carry trade. Review this on the online notes and don't be surprised if it pops up on the exam this Tuesday. For an excellent video clip concerning this, click here. As investors cashed in their overseas investments, they paid their yen loans, since the primary risk from the carry trade is the yen appreciating relative to the US $. Clearly, that had been happening all week. As I write this, the dollar-yen exchange rate is below 95 yen/$.

To determine how markets will do this week, check out the week's economic schedule. On Thursday, we get the first read on third quarter GDP in the US. IF, as many of us suspect, this will come in negative or very small, the global recession scenario will be reinforced, causing heightened market weakness, in spite of whatever market momentum might occur on Monday through Wednesday. Stay tuned!

Worst Week Ever?

This past week was a very trying one for the stock market, as all of you know. To see how bad things have become, notice that even the financial "experts," whose ridiculous recommendations have led so many to live in mortal fear of their 401(k) statements, are suddenly humbled. Gone (for now at least) is their truly outdated advice to "buy and hold," "dollar cost average," and based on forward price-earnings ratios, conclude that the market is very "cheap." Their only refuge is the assertion that when the market does bottom, it will probably rise by as much as 30 percent. Given the inherent conflict of interest these persons bring to the media, they make money from stock transactions, they are still trying to drum up business, but doing it in a more subtle way. Here is a video clip summarizing the past week.

This is where the power of technical analysis comes in. Asset prices are leading indicators of fundamental information. And, in times like this, where future earnings, etc. are incredibly uncertain, you can use the real-time information provided by markets to guide you.

How should we view Friday's market activity? Support at 8,000 (going back several years) for the Dow-Jones ($INDU) held. More importantly, while the market fell sharply at the open it then recovered quickly for a wild ride. The following chart from StockCharts.com will help you see this (click on it to enlarge). This shows the last two weeks of market data for the Dow-Jones.

First, look at the bar from eight days ago. It looks like a cross. In candlestick analysis, this is referred to as a "doji," which signifies indecisiveness - the bulls and bears fought a battle that nobody won. Note how short the bar is -- the gap between high and low was very small. Both features point to the possibility of a momentum reversal. Now go to the next day. Still a short bar, but the market closed near the low of the day, and close was below open. Not good for the bulls! The next day is even worse for the bulls: close at the day's low (near very short-term support) and an upward tail (undefended territory).

Now let's focus on the last two days, after apparent support (around 10,300) began to become a distant memory. The bars got much higher, so the daily battle of bulls and bears was intensifying. For Thursday, close was at the day's low. Ugh! For Friday, there was a large sell-off at open that probably produced much "panic" selling, so the day's low was within the first hour of trading. Then the market pulled up noticeably -- even though it was still down from the previous day. It went positive at several points, so the high was above the open, and by 3:30, the market was up by around 330. There was selling toward the close, so there was undefended high territory and the day's close was down 128 points.

Most people will focus on the fact that the market was down again, this time by 128 points. YOU should focus on the facts that: (1) the close and open were fairly close; and (2) a large lower tail emerged on Friday. Lower tails suggest the possibility of a bottom, or weakening of downward momentum. Consistent with this, the RSI(9) is also in very oversold territory.

So, my interpretation is that we are possibly very close to a temporary bottom, as support at 8,000 held, the RSI indicates oversold conditions, and a large lower tail emerged on the most recent daily bar. A few negative notes from the credit market: the 1-month t-bill rate remains below 0.10%; and while the overnight LIBOR rate fell sharply on Friday, the one and three-month rates remain elevated. NEVER OVERLOOK THE CREDIT MARKET!

How can we further decide whether this bottom will hold? How about economic theory? What a coincidence, that's what ECN 327 is all about! What determines stock prices? Interest rates (asset substitution, etc. that we covered in class) and most importantly expected future profits. So, looking forward, you need a forecast of the overall economic picture -- both national and international. But, for extra credit (due at the beginning of class on Tuesday), bring in two graphs, one with daily data, with annotations, showing support and resistance, the other repeating this for weekly data going back as far as possible.

This week should be a very important one for the future of this stock market downturn. Will the G-7 meetings produce tangible results? If not, will the market sell-off further? Will credit markets start to loosen and begin more normal lending again? Follow the bars each day and interpret them for what they convey. Practice like this will help you further understand charting and the information it provides.

Big Story: Sharp Interest Rate Increases Last Week

This coming week we will be discussing and modeling interest rates. Ironically, during the first week of class, the 10-year bond rate went all the way from 4.77% to 4.88%, an eleven basis point increase. That might not sound like much, but it is significant, especially since mortgage rate changes tend to be highly correlated with movements in the 10-year bond rate. Expect to see higher mortgage rates reported next week. Read this story to see more about this.

What we will see this coming week in our model of interest rates is that stronger economic growth pushes interest rates higher (other things being equal). That is what happened Friday, with stronger-than-expected reports on Durable Goods and New Home Sales. There was strong economic data earlier in the week as well.

You can plot the 10-year bond rate on StockCharts.com using the symbol $TNX. Follow the handout material I distributed on Thursday, switch to OHLC bars, but customize the time period (change RANGE) to Select Start/End, and use the time period Jan 22, 2007 through today (that will be Friday). Click on UPDATE. You will see the following graph (without the comments embedded). Click on the graph to enlarge it:
















Q: Is this week's run up in the 10-year bond rate due for a pause, or will it just continue?
A: Use technical analysis to provide an answer to this. Note in the graph how the "interest-rate bulls" (which we will see are actually bond market bears, since higher interest rates mean lower prices) dominated this market from Tuesday - Thursday, as the close each day exceeded the open. On Friday, things reversed, as close > open. So, a momentum shift occurred on Friday. We can also use the RSI indicator to help with this (see handout I gave). First, change the default value on RSI from 14 to 9. I highly recommend that you use 9 in the future. As of Friday, we can see that the momentum had shifted, based on the above discussion, AND the RSI was in the overbought range (RSI > 70). This indicates the likelihood of a short-term pause. IT DOES NOT GUARANTEE ANYTHING, HOWEVER!! We will see if this is what occurs next week.

Q: If the 10-year rate does decline, where is it likely to move to?
A: SUPPORT.

Note that by not just following the close each day, but looking at the high, low, open, and close, we are provided with a great deal of added information and insight. While Friday's close was higher than that of Thursday, the fact that on Friday, the close fell below the open, provides a critical insight that you just can't see by restricting focus (as so many persons do) to closing value only.

British Pound Nearing Record

The dollar has weakened against several major currencies over the past week. One of the most important currencies the dollar has depreciated against is the British pound ($XBP). The US dollar - pound exchange rate is now approaching $2. Using technical analysis, is there any basis to conclude that the current high values will continue to move higher?

First, it is important to establish whether the value the pound is approaching, $2, is a resistance level. To do this, remember the basic rule: Look left. What I have done is to extend as far back as far as my subscription allows (to the late 1980s). When going this far back, it is necessary to use monthly data so the graph doesn't get very messy.

When doing this, first, clear off the moving averages that are on the StockCharts.com graphs (the 50 and 200 period). Experiment with values and find a period that fits the most recent upsurge very well. In the present context, the 48-month moving average does this, as the graph shows (click to enlarge).

Examination of the graph shows that $2/pound is a very long-term resistance level that dates all the way back to the early 1990s. So, I have drawn a horizontal line to designate this fact. Support is the 48-month Moving Average.

Is it likely that the pound will break above its long-term resistance? The answer is yes, in the near-term, though. Note that the RSI is not yet at or above the overbought reading of 70 yet, so this indicates there is more upside possible. Also, below the main graph I have added a graph that shows how far the actual values of the pound are from the 48-month Moving Average. Apparently, 20 is the resistance level for that divergence (note: this is 20 cents). At present, the divergence graph below is not yet at 20, so this also appears to confirm that there might be further upside for the pound.

Remember, this is a likely outcome, not guaranteed. And, if the pound does move beyond its long-term resistance at $2, it will become overbought fairly quickly thereafter, as the RSI is very close to 70. So, whether a move above $2 can be sustained after it occurs is open to question.

As I have stated in earlier posts, use economics to determine whether the move after $2 (if it does occur is up or down). To do this, you must essentially formulate a forecast of the pound. A key factor is US monetary policy. Also, will the European Central Bank raise rates for the Euro zone? If so, relative US interest rates will fall (as the Fed is on hold with rates for now), causing the pound to appreciate further. See if you can identify other factors that will determine likely future values of the pound.

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.