Thursday, April 19, 2007

Technical Thursdays: Divergences and Moving Averages

As a strong advocate of technical analysis, I have found certain tools to be superior to others. One such tool that has been written about several times on these pages and in my reports is Divergences.

Divergences come in two forms. One deals with the divergence between two indices. The other is the divergence of an index with its key indicators. In this week edition of Technical Thursdays, we look at a few charts that illustrate the first form, index to index. The other tool of great use is the Moving Averages.

As most investors know, moving averages smooth out the day to day fluctuations (some say noise) and help put a market trend into some longer term perspective.

On page 3 of this report (see link below), we look at the three primary moving averages (10, 50, and 200 day) and analyze the relationship between them and the current price of an index.

Dow Theory: Measuring one index against another helps to confirm a market trend. The granddaddy of index comparisons is the Dow Theory: Matching the Dow Industrials against the Dow Transports.

The first chart shows the current bull market and one can see that while there have been a few points in time when the one failed to confirm the other’s new high, those periods were brief and the confirmation gap to close was fairly small. (Example: late 2006. Dow Industrials makes new highs, Dow Transports do not.) Now, consider the difference between the above chart and the following: the period between 1998 and 2000.

Here one can see that the gap is quite substantial. (Industrials make new all-time high in early 2000, Transports are close to 50% away from confirming.)

Moving Averages: This long-term chart of the S&P 500 shows very clearly the mega trend value in the 200-day moving average. Throughout the 1990’s bull market, the slope of the 200-day moving average was always up. It wasn’t until price and the two shorter-term moving averages (10 and 50-day) crossed the 200-day that its slope pointed downward. That downward slope remained intact until early 2003, when, once again, price and the shorter-term moving averages crossed, this time to the upside.

Another, more near term, facet of the moving averages is the price of an index (or stock), the relationship between the three moving averages, and their slope. To illustrate, let’s view the past 4 years.

The most bullish mix is price above moving averages, moving averages above each in time (10-day above 50-day above 200-day), and each moving average upwardly sloped. As the chart below makes clear, it is easy to see why a number of market technicians state that the current bull rally is the start of a new major uptrend. (see 2003 versus 2006).

A normal corrective phase occurs when price and the shorter-term moving averages turn sideways to down. Here, too, many bullish technicians point to the normal corrective phases of such shorter-term market action. Note: while price and shorter-term moving averages have crossed the 200-day, at no time does the 200-day turn down.

Investment Strategy Implications

Using just these two valuable technical tools, the current bull rally shows no signs of a major trend reversal. The only risk to the current bull market suggested by the two tools is exactly what we have experienced: sudden, sharp pullbacks in a fully synchronized, highly correlated market (spring 06, late winter 07). Unfortunately, the nature of the sudden, sharp corrections in a fully synchronized (both domestically and globally) is very unpredictable. The two nasty declines recently experienced burst on the scene with little to no advance technical warning*.

*Note: Sentiment did become overly bullish and certain other indicators did flash modest warning signs. However, there were no major market signals that would have warned of the severity and suddenness of the decline.

The overall recommended investment strategy is to lean against the wind. As the equity markets surge ahead, take some money off the table (and selectively short vulnerable countries, regions, sectors and styles). During market corrections, reduce the underweighting and rebalance the portfolio as needed.

Accordingly, the Model Growth Portfolio is presently less than fully invested, as noted in the report.

To download the report, please click here

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