Spotting a Bottom

While many things happened today, most notably this was an up day (yes those actually occur from time to time), I thought I would write a post showing a classic bottoming pattern in technical analysis. This can be seen by referring to GE (General Electric), which has been totally beaten up over the past year, mainly because it has a large financial segment. The chart below shows daily action for GE (click to enlarge):
First, let's forget about support. There is enough information to overlook that at present. Note that the chart shows GE to be VERY oversold at present. Now, focus on today's bar. It illustrates something that often occurs at bottoms: there is a large and significant lower tail (below the closing value). Even though today's close was lower than the open, the bears, who at one point were able to get price much lower than the closing price, were largely rebuffed by the bulls who were able to reverse much of the bears' negative momentum. In candlestick charting, today's bar is called a hammer, which "hammers a downtrend shut."

There is further reason to consider today's bar as significant: it occurred with extremely high volume. This is indicative of capitulation -- the "soft" money gives up and sells off, leaving only the "firmer hands" that will likely move price higher. This is an example of what I often refer to as "shaking the tree."

While today's action has all the makings of a short-term bottom for GE, there is no guarantee that it will actually be the bottom. Confirmation is required from tomorrow's price action: will tomorrow's trading move price above today's high? If so, there is reason to expect follow through. Of course, if more financial "shoes" drop, if tomorrow's initial claims data is a disaster, or if Friday's employment data are worse than the whisper number of around -850,000, all bets are off.

I suggest you follow GE for the next week or so and see how this plays out. To help you further, I have also added the chart for GE as most people look at it: closing prices only with no technical indicators. What would you conclude from this chart???

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.

Q4 GDP Surprise?

On Friday, the second round estimate of Q4 2008 GDP was released. Originally, the real growth rate for Q4 was -3.8%. But, as I noted in class, that release only approximated inventories, exports, and imports.

The value for Friday's release was fairly close to my expectation. My prediction was for a downward revision to -5.5%, but I didn't rule out a drop of around 6%. That's what we got: -6.2%. The media tried to play this as a huge surprise, but many economists saw this coming. Markets gyrated throughout the day. The Dow-Jones average started the day down over 100 points, eventually moved into positive territory, then closed down 119. ALWAYS PAY ATTENTION TO THE WEEKLY CLOSE. The ten-year bond rate closed above 3 percent, which will likely remain in force as budget deficit projections continue to rise.

The major revisions contained in the revised GDP data were a worse-than-expected fall in exports and a sharp downward reduction in inventories. Read this article about the report. Actually, the fact that inventories are much smaller than first estimated is a very positive sign. Inventories are a leading economic indicator - their behavior today signals likely changes in economic activity 3 to 6 months in the future. So, with the new inventory estimate, businesses have far less inventory to work off in future months, meaning they have already begun to work through this problem (review the Quantity Adjustment Mechanism from Supply and Demand notes). Unfortunately, working down inventories will continue for much of this year, as national and global weakness persists.

On Friday, the Dow-Jones average closed near the low of the day, which moved us very close to the 7,000 level. Next Friday the February employment data will be released. That could move us below 7,000, but only if there were very big surprises (a nightmare decline in employment, and a sharp rise in the unemployment rate). I'm not sure we'll see that as the markets have already priced in very bad employment data, especially in light of Thursday's initial claims level.

Gold Breaks $1,000

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

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

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

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

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

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

Sector Rotations and the 200-day Moving Average

Bloomberg's had an excellent interview with John Murphy, the author of this course's Intermarket Analysis text. Here is a link to the You Tube interview. You will probably need to play it a few times, but take notes and try to understand the role of gold (here's an article to help), how the 200-day moving average has significance in reading the market, especially for selecting stocks, and how to use sector performance data as a leading indicator for when the overall stock market will bottom.

Today's market behavior moved us closer to testing the Dow-Jones and S&P 500 average bottoms from November. Note that the media refers to closes as bottoms, while technically lows should be used. If reaction tomorrow to the President's plan to control foreclosures is tepid or just plain hostile, we should test the November lows. Study today's OHLC bar and where the RSI(9) is relative to giving an oversold reading. Then strap your seatbelts for tomorrow's market action.

Gold Rally?

I have heard an increasing number of "talking heads" in the media recommend investing in gold. You can track gold using $GOLD (it is end of day values, though) or invest in it through an Exchange Traded Fund, GLD. How can such recommendations in general be evaluated?

Many persons watching or listening to the "talking heads" of course just rush into recommended investments. After all, these people have been analyzing markets for years! But, as we have discussed in class, experience is a sufficient but not necessary condition for competency in a given field. Then there is consideration of the short term versus longer term. Technical analysis and economics can help with both of these. Although there are never any guarantees, just a higher probability of success based on systematic analysis, the benefit of this combination is that you can check to see where mistakes occurred after the fact and improve your economic analysis.

A further edge into this is provided by intermarket analysis. As we have already discussed in class, gold and the US Dollar tend to move in opposite directions, as gold and other commodities have prices stated in US Dollars. For extra credit, due at the beginning of class tomorrow (2/17), prepare a Word document were you paste a graph of $GOLD and the US Dollar Index in the same graph, converting each to line charts (from OHLC). Is the relationship between this pair that expected from intermatket analysis at present? Explain why or why not (write a few sentences to explain this), after reading about the recent behavior of each from sources on the Internet, etc. Then, in a separate graph (you can go back to OHLC), have both gold and the RSI(9) in the same chart and paste this into your document. What does the relationship betwen gold price and the RSI indiacate about any "legs" the short-term gold rally can be expected to have? Write a bried explanaton of your answer.

Finally, today Japan reported a quarterly (sequential) change in real GDP of over 3%! This translates into an annualized decline of around 13%. OUCH!! You can read about this. What did the Japanese Yen do in reaction to this? It actually rose, believe it or not! Clearly, this is yet another instance where "other things" are not equal.

As the semester progresses, think about how weakness in Japan will likely affect the global recovery (they are the #2 economy in the world), and how this might play into your forecast.

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.

January Employment Report

Friday's employment report was very close to my expectations -- very bad. As I stated in class on Thursday, my expectations were for payroll employment to fall by 550,000 and the unemployment rate to rise to 7.7%. The actual employment change was -598,000 and the jobless rate rose to (only) 7.6 percent. Read a story about this report. Also, view a video, the Short View by John Authers of Financial Times.

Reaction by markets was very likely the opposite of what you had come to expect. I will focus on only the stock and bond markets in this post.

The stock market actually rose by 217 points. There are a couple of reasons for this. There is a formal expectation for major numbers and what is called a "whisper number" -- what markets really expect and have braced for. The whisper number for employment was a decline of over 600,000, so the actual number was not much of a surprise (or scare). The whisper number for the unemployment rate was around 7.8%. So, in a sense Friday's stock market rally was a sigh of relief -- we apparently have dodged a bullet. But there is another level of causation involved.

The January numbers were so bad that markets have now discounted for the fact that some stimulus package will definitely pass -- and soon. Furthermore, Treasury Secretary Geithner is expected to announce a new round for TARP funding, and as of Friday, markets reacted to the "rumor" (their visions of what will likely occur) as they so often do. But there is a very old saying in the stock market: Buy on the rumor, sell on the news. So, when the actual details of the Treasury program are eventually released, apparently on Tuesday, expect there to be somewhat of a letdown, as reality seldom matches expectations, potentially resulting in some stock market giveback.

Technical analysis tools help in evaluating the likelihood of this. First, the RSI(9) for the Dow-Jones Industrial Average ($INDU in StockCharts.com) just moved over 50 on Friday, a bullish sign, and nowhere near an overbought reading (at 70). But, a look at recent highs in late January indicates that there is resistance point not far from where the market closed for the week. So, we have a toss up based on technicals.

What about the bond market? Review the online notes from Thursday. Interest rates rose on the "good" news, which means the bond market sold off (lower bond prices). Persons sold bonds, which lowered bond prices and raised interest rates, and moved into stocks, raising stock prices. This is a very typical "rotation, the reverse of a flight to safety. The ten-year US government bond rate rose to almost 3%, which is stunning since about a month ago it was threatening to break below 2%.

If we assume, as is quite possibly the case, that interest rates have bottomed, then bond prices will be falling from this point forward. If you were an investor, how could you "play" this expectation? There are inverse Exchange Traded Funds (ETF's). For bond prices, the symbol is TBT, the double inverse (i.e., ultra short) for 20+ year bonds. Check this out and graph it on StockCharts.com. Is there a trend? If so, which direction? Where is support? Resistance? What do the RSI and relative strength indicate? Please note: I AM NOT RECOMMENDING THE PURCHASE OF THIS ETF.

As I finish this post (11:30pm Sunday night), the Dow-Jones futures are signalling an opening that is down about 92 points from Friday's close. This might well change. But keep an eye on markets after the Treasury announcement on Tuesday.

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.