Thursday, September 13, 2007

Technical Thursdays: It’s a Bull Market ‘til it Ain’t


Next Monday evening I will attend the retirement party for technical analysis legend Ralph Acampora at Grand Central Terminal in New York. Over the years, Ralph has been both a mentor and friend. His participation in numerous events that I have produced and conducted over the past decade has enabled many to gain from the market insights he shared. There isn’t a more generous person that I know than Ralph.


In having the benefit of hearing Ralph these many years, a common theme comes through – don’t over complicate your analysis. Keep your eye on a few important balls as they matter most. It is a message that I try to adhere to (my “critical variables”). It is also a similar message to the one I heard Jim Barksdale (of Netscape fame and a panelist at my Jackson, MS Market Forecast dinner earlier this year) say time and again – “keep the main thing the main thing”. With that solid advice from two extraordinary people, take a moment to consider a very simple technical analysis tool, the granddaddy of all technical analysis tools – the Dow Theory.

As the chart above* shows, there has been no divergence between the Dow Industrials and Dow Transports. To be sure, over the life of the current bull market there have been moments when a non confirmation** occurred for a while (mid to late 2006 is the most recent example) only to be confirmed a few months later.

Going into the current correction, the Dow Theory did not generate a sell signal. Moreover, when taken in conjunction with other simple yet important market indicators such as the moving averages (see blog entry of August 2, 2007), the only reasonable conclusion I can come to is that the correction we are in is…well, a correction and not the start of a bear market regardless of the angst of a potential recession or sub prime inspired contagion.

Investment Strategy Implications

There is comfort in numbers. Too often in today’s markets momentum “investing” takes the place of independent analysis and thinking. After all, careers can be wrecked by marching to the beat of a different drummer. Much better to stay close to the pack. It increases the chances of not getting fired for being too off the mark. Gotta keep that house in Greenwich.

I believe that this herd thinking is manifested in the record high correlations between and within asset classes. You see this in the willingness to surge then purge into and out of investment positions. For those with a contrarian bone in their bodies, this is a pattern that can and should be exploited. And something worth remembering should either Dow Theory components break to a new low anytime soon and the momentum lemmings jump off the cliff.

Thank you, Ralph, for many years of great advice and counsel. And thank you for your friendship. You will be missed but never forgotten.

*To view a larger version of the chart, simply click on the image.
**One index makes a new high or low while the other does not.

10 comments:

Anonymous said...

I'm not sure how you created this chart, but when I look at the $indu and $tran on stock charts there is a clear divergence.

Vinny Catalano, CFA said...

Where do you see the divergence? What time period?

Anonymous said...

Maybe I am wrong here, but if I go into stockcharts and I put in $INDU as the main chart, and then go below and put $TRAN behind it, it clearly shows $TRAN cutting under $INDU. If I am looking at this the wrong way, please do correct me. Thank You.

Vinny Catalano, CFA said...

I see what you are referring to. Let me clarify what I mean by divergence.

Divergence pertains to the price of one index to itself versus another index to its self. If index A makes a new high (or low) and index B also makes a new high (or low), then you have confirmation. No divergence. However, if index A makes a new high but index B does not, that a non confirmation, a divergence.

It is the price action of the index to itself compared to the price action of another index to itself that creates the confirmation or divergence.

Now look at the chart I have posted (or the one you have). Whenever a trend is in place, higher highs by one index must be confirmed with higher highs by the other index. If not, a divergence has occurred.

Does that help?

Anonymous said...

Thanks, I really liked your article and I was trying to setup a chart that would replicate yours but could not. Do you have any suggestions as to how I can replicate it in stockcharts?

Vinny Catalano, CFA said...

You're welcome.

I use bigcharts.com. However, you should be able to do it with just about any chart service.

The time period I used is 2 years.

Anonymous said...

Okay I got it and recreated it with bigcharts. While I can see for the most part that there is not much divergence, what on this chart would indictate to you a clear divergenance? Would it be a crossover of the two indexes?

Thanks

Vinny Catalano, CFA said...

Pls try to delete the cross over part from your thinking. It is only an index's price action to itself versus the other index's price action to itself.

You are right. At present, there is no divergence. Hence the title of my blog. But in mid to late 2006, there was a divergence.

The Dow Industrials make successive new highs while the Transports did not. Where it not for other factors (see my moving averages comment in the blog posting), a sell signal would have been triggered as a major divergence occurred.

In early 2007 when the Transports finally made their new high, then the divergence was negated.

One additional point - this is one of several important yet easy to follow indicators. Another would be the moving averages one I mentioned. The point is that only when several important indicators give the same signal (bullish or bearish) can a trend change be stated. That is why the bull market is intact and that I believe we are in a correction and nothing more.

StockRake said...

I got here because I quoted an old article from 1998 with Ralph Acamoira in it in regards to the "two tumbles and a jump" idea from Fosback.

I have noticed on a few stock blogs where they do think there was a Dow Theory sell signal, but I didn't see it either and its so not my specialty.

Technically I agree, we are nowhere near a bear market or even starting one right here.

Most indexes are still above 50wma. Bear markets don't happen without price being under that avg. Nothing is saying bear market here, but there is a ton of a fear out there.

Vinny Catalano, CFA said...

What I look for is a major market top. WIthout a major top having been formed, the technicals of the market do not indicate anything more than a correction, which is what I think we are experiencing right now.

To see what constitutes a major top, pls review my prior entries, particularly the Technical Thursday entries.

Don't who is calling for the Dow Theory to have given a sell signal. Without a divergence between the two indices, there is not sell signal.