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.

NASDAQ Support at the 50-Day Moving Average

The market has now been in correction mode for a few days now. Focusing on the NASDAQ, as of last Friday, the RSI was in overbought territory and a Doji appeared. Since then, the NASDAQ has been lower. But it is important to see that sometimes a "psychological level" can provide either support or resistance. In the present case, the 50-day moving average has become support for this NASDAQ's pullback, as the chart shows (click to enlarge).

Note how changes occurred right at the (rising) 50-day moving average. While the RSI remains below 50, the traditional value above which a bullish trend is viewed to be in place, it does still remain above 40 -- a level that can be viewed as support during an uptrend.

Does the uptrend remain in tact? Remember that an uptrend means higher highs and higher lows. At the present time, the recent lows remain above the low from the end of January, so the uptrend is still in force. Also, note the increase in the RSI over the past few days. This too provides some reason for optimism.

The fate of oil production and shipping in the Middle East will ultimately determine whether the present support level holds. However, the February employment number will be released on Friday morning (8:30am). This will be pivotal. A very bad number then absent weather influences, will very likely cause support to be broken -- for now.

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.

GDP Surprise

Friday's GDP report, the preliminary look at Q4 economic performance, was surprising. The consensus was for about a 4 percent gain, but the number came in at 5.7 percent. This was an excellent example of how "good news" impacts interest rates: good news tends to cause higher interest rates, as we discussed in class the other day. Here is the link for an article discussing this.

Initially the stock market and interest rates rose as the results were released. By the end of the day, however, things had changed.  The chart (click to enlarge), which uses 60-minute OHLC bars, shows how the ten-year US Government bond reacted throughout Friday's trading. First thing to note, the actual interest rate is 1/10 of the value listed on the right scale. So, for example, 36 corresponds to 3.6, etc. Second, note how closing values exceeded opening values for the first two bars (hours). How could we figure that momentum might begin to shift? Look for upper tails, where the bulls were unable to support high levels, and by the end of the time period, bears had pushed values lower. After the second bar (hour), things turned around for the rest of the day, as close was below open each hour. By the last hour, there was essentially a "toss up," as open and close were almost identical.

Why did rates reverse on the "good news." Much of the overall GDP growth was the result of inventory effects (3.7% of the 5.7%), which will not persist in coming quarters.So, while this GDP number was a surprise and good news, interest rates, like asset markets in general, are forward looking. So the news in coming quarters might not necessarily be all that much better than what the markets had been anticipating prior to the GDP release. More data, primarily for this actual quarter, will be needed to move the direction of interest rates from where they were that day. Support, though, appears to be at 3.6 percent. Will this level hold? As the course progresses , I will show you how to use economic models to make an educated guess at questions like this.

Fed Decision?

As expected, at 2:15 today the Federal Reserve made its decision not to raise rates (thank God!), and released its short statement summarizing its assessment of the economy now and in the future. Here is a copy of the actual Fed statement. And, as I indicated to you in class, the media provided an anal and microscopic evaluation of this statement compared to the previous one (click here).

How did the stock market react? Below is an image of the S&P 500 using 15-minute intervals (click to enlarge). Look this over, as a number of the key elements for reading market momentum show up. First, note when the announcement occurred at 2:15. The initial reaction was very positive (large up bar). But, that wasn't sustainable, as the RSI(9) showed an overbought reading (above 70). The next 15 minutes, we see a classic illustration of what happens when momentum diminishes -- a bar with a significant upper tail. This indicates that the bulls were able to push price fairly high, but the bears ultimately beat them back. For that bar, note the close (of the 15 minutes) was almost identical to the open. In the next bar, the open was above the prior bar's close, but things got bad for the bulls as the bears were clearly in control at this point. Take a look at the last bar of the trading day - a large range, the bears were clearly in control by then, and the close was almost at the low for that 15-minute period.


The day ended with an ugly price bar, but a glimmer of hope for tomorrow -- the RSI was giving an oversold reading (was below 30). If price should continue to fall, how low can we expect it to fall? Let me restate this: where is the next level of support? To find this, use the rule from class: look to the left. In other words, extend the time period of the chart. In the second graph (click to enlarge), I have extended to 5 days. From this, we are able to see the next level of support at around 1058.

Let's see what happens tomorrow.

Oil Price

As I stated in class today, oil prices ($WTIC) have recently made, but not completed, a double top. The chart (click to enlarge) shows this, along with how to calculate the target price. First, it is important to point out that for a double top formation to be completed, market price must break below the neckline, which has not yet happened (also, remember this chart is EOD, or End of Day). The calculation of the lower price target is given on the chart. In the present example, assuming that this pattern is completed, so that price closes below the neckline, the falling price target is just under $40/barrel.

I have drawn a horizontal line at (approximately) that price target. Something interesting emerges: if the target is reached, we can expect a re-test of support that has existed since the beginning of 2009. Notice that there were a few false breakdowns below this support in February, but support there held.

The important question for ECN 335 is the informational content of this formation. In other words, what is this market telling us about the direction of the overall economy, commodity prices, or other factors in the near term?

Start by modeling oil prices (and commodity prices in general): demand for goods (predicated on production), and the strength of the US Dollar are major factors. In addition to these, factors specific to this particular commodity (ex: geopolitical problems concerning oil production) should also be taken into account. Next, view oil price alongside other indicators such as cyclicals ($CYC) and determine whether it is a lagging, coincident, or leading indicator (read Carnes & Slifer's text to help with this).

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.

What's Next for the S&P 500?

The S&P 500 fell all the way to 700 today, which is support going all the way back to 1997. Clearly, financial sector problems, most notably the ongoing problems with AIG (where was Rick Sentelli's rage about the government's action today??), and HSBC, the largest European bank curtailing lending in the US, hurt markets in general.

In order to find the next support levels, go to StockCharts.com, switch to Weekly data, and to make things visible, enter a specific time period. I chose 1996 - 1997 to see things without too many small OHLC bars. In order to find the exact LOW for support, in Annotations, change the Info Mode of the Cursor (far button on top right of Annotation screen). Click two times until it gives the date and specific values for Open, Close, High, and Low when you move to a bar.

I did this and found the next two support levels for the S&P 500 (note: this is depressing, viewer discretion is advised), which is given on the following chart (click to enlarge). Next stop is 644, which is a pretty significant drop from today's level. After that, the next support takes us almost to 600 (at 606).

To determine whether we will likely hit either of these support levels, once again use economic analysis. The primary determinants of stock price at present are proft expectations and the perceived safety of the financial system.

Considering just these factors, we go 0 for 2, so the likelihood of reaching 644 suddenly becomes very significant. But at times like this, don't forget the psychology of markets.

A few weeks ago, many of the "talking heads" were saying it was time to get back into the market. Recall, my advice at that time was to get out quickly if you had money invested. Now, there is almost total resignation that a sharp drop is inevitable. Being a contrarian, I see the potential basis for a short-term bear market rally. So, barring any more horrible news (remember we have the employment report Friday), we might move up shortly.

The initial claims news on Thursday will probably bring more downward price pressure so it is not inconceivable that after a very bad employment report on Friday, we have an initial downdraft followed by a short-term rally. Think about it for a while: if a rally were to occur, when would most people be fooled? Answer: Friday after the employment report. This is only one possibility. Let's see how things actually play out for the rest of this week.

Very Long Term Support

As I am at office hours, doing my ongoing impression of the Maytag Repair Man, I thought I would finally do something I had avoided: find the very long term support points for the Dow-Jones Average. To do this, I had to convert to monthly bars (I can do this since I have a paid subscription), and went as far back as 1994. Here are the results for support should the current support of 7,475 fail:

Support #1: October 2002 = 7,198
Support #2: October 1997 = 6,933
Support #3: April 1997 = 6,316
Support #4: July 1996 = 5,170

The only good news here is that with the monthly chart and current levels of the Dow-Jones Average, the RSI is giving an extremely oversold reading of 13.3, which is its lowest reading by far over the entire period from 1994 through 2009. While this suggests a short-term bounce up, it is important to keep in mind that markets can remain in oversold territory for a while before such a bounce occurs. This is particularly true when analyzing monthly data.

NOTE: I have used lows, which are most appropriate to determining levels of support. The media generally uses closing values for this, which is technically incorrect.

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.

GDP Report

On Friday, the preliminary GDP estimate for Q4 of 2008 was released. The number indicated a decline of 3.8% (versus Q3 -- an annualized change). This is well below my expectation of -4.5%, and the consensus figure of -5.5%. However, the preliminary (first-pass) number is based on estimates of inventories and net exports (exports and imports).

Interestingly, both inventories and net exports made positive contributions to the Q4 number. Personally, I believe these will be very different when the second pass number is released in a month, so I am sticking with my expectation of -4.5% to -5%.

What did the stock market do in reaction to the GDP number? After a brief and weak rally early, the stock market closed down. The Dow-Jones Industrial Average closed right at 8,000 (a fall of 148), which is a support from a few months ago (think of this as Support #1). Will that hold? Next Friday the employment number for January will be released, and it promises to be UGLY!! So, it is likely that we will test Support #2 of 7,962 from mid-November, especially since the RSI is not yet in oversold territory.

The bond market likes weakness (remember from class: bad news is good news in the bond market), so rates dropped slightly (this was not much of a surprise to bond traders). Commodities (in terms of the CRB Commodities Index) rose slightly, as did Oil and GOLD.

In my mind, the most significant trend from intermarket analysis is that in spite of Friday's result, the bond market might have already turned up (rising interest rate trend, falling bond prices). As Murphy discusses in his text, historically, BONDS LEAD STOCKS (and Commodities). So, if the bond rates have bottomed, we might see a stock market bottom by the fourth quarter of this year.

If you have not done so yet, purchase and read all of Stikki Stock Charts, download my handout for getting started with StockCharts.com, and try out the things in the handout. I will hand out material to you on Tuesday.

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.

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 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.

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.

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?

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.

Soft Landing?

The economic indicators released today raised serious questions about how rapidly the overall economy is slowing. Prior to today, the consensus view was that economic growth would continue to slow, but not by enough to seriously crimp profits. Along with this, the Fed would be done raising rates, and might even begin rate cuts by the middle of 2007.

Two reports in particular, the Philadelphia Fed's Economic Activity Index was a negative value, well below the concensus (of around 13). Also, the Conference Board's Index of Leading Economic Indicators fell for the fourth time in the last five months. Hardly an endorsement for future economic strength. Read about these developments in an article.


















This percieved future loss of economic strength affected interest rates. The benchmark 10-year government bond fell by 8 basis points. Furthermore, by the end of the day, this rate had fallen to its support level from mid March. I have provided a chart using StockCharts.com (click on the graph to enlarge it). Note that at its present level, the 10-year is only slightly overbought and that short-term resistance is not the 200-day moving average. (NOTE: divide the right-side scale by 10 with this interest rate)