Thursday, May 8, 2008

The “Inflection Day” Rally

The granddaddy of the market confirmation principle, Dow Theory, states that each index (Industrials and Transports) must confirm the other in order for a move (up or down) to be considered sustainable. If one index makes a new recovery (not all-time, necessarily) high or low, the other must confirm that move with its own recovery high or low for the move to be considered sustainable.

In what is becoming known as “inflection day*”, March 17 witnessed the Dow Industrials break to a new low but the Transports failed to confirm that low (see first chart**). Subsequently, stocks marched ahead with each successive new recovery high in each index being matched by the other.

For some less-schooled market technicians, that’s all she wrote. We currently have a non-confirmation that occurred on inflection day and its off to the upside races. For the moment, let’s accept the trend call of the Dow Theory but not stop there. Let’s incorporate a few other indicators (specifically momentum related) and try to patch together a technical analysis forecast for the next several months (something that efficient market types say is impossible).

The second chart** provides several detailed momentum related indicators that I have found to be of considerable short-term value. A close examination of the Momentum, MACD, and Slow Stochastics indicators for the relatively strong Transports all point to one conclusion – the current rally has weak momentum underpinnings. Momentum has failed to produce a higher high, MACD is at a crossover point (to the downside), and the ultra short-term Slow Stochastics has already crossed and is headed south.

None of the above indicators suggest a reversal of the current rally. However, they all point to what is likely to be a very short-term mediocre to down period (probably lasting until Memorial Day, the unofficial start to summer here in the US). After that, a summer rally seems to be in store as the non-confirmation signal on inflection day was followed by a confirmation signal thereafter.

Investment Strategy Implications

Technical analysis (TA) is one tool that can be relied upon for market timing and portfolio strategy purposes. The above signal (one of several in the TA toolkit) suggests a tradable rally into the summer after a brief respite in the very short term***. The other tool, fundamental analysis, tells a decidedly different story – one that will play out into the fall and 2009. I suspect that the technicals of market will begin to signal that ugly period once the current inflection day rally has run its course.

*Bear Stearns deal (steal?) results in a change in the credit crisis.
**click images to enlarge
***expect to hear the tired phrase “sell in May and go away”.

1 comment:

NewstraderFX said...

The transportation index signaled the exact low on March 11 for the DOW. On that day-transportation (on the daily chart) made a bullish Double Stochastic Over Sold indication.

A DS OS is made when two closing prices on different days close with their stochastic indicating oversold, with the second price closing higher than the first.

On May 2, bearish Double Stochastic Over Bought indications were made on the DOW and S&P 500 (weekly charts).

A DS OB is made when two closing prices on different days close with their stochastic indicating overbought, with the second price lower than the first.

The weekly charts remain DS OB (bearish) but the dailies are DS OS (bullish) an occurrence that I cannot find ever happening before.

It's likely to see the markets trend up over the next few days, but once they become DS OB, the daily and weekly charts will agree and the weekly downtrend will proceed. Weekly DS indications are fairly rare, so I would expect the downtrend to be rather protracted.

If you follow currencies, you know that USD/JPY and carry trade pairs such as EUR/JPY and GBP/JPY follow the S&P. USD/JPY and all the JPY crosses made bearish DS OB indications on May 2, right along with the DOW and S&P (weekly charts).

The S&P itself is in a rather unsustainable position vis a vis EPS and the P/E ratio.

As I'm sure you're aware of, the market follows EPS and indeed, the EPS line was above the S&P for most of the bull market. EPS flattened over the summer and has fallen since, taking the S&P with it. However, EPS has continued to fall since the rise in the S&P from March 11, a situation that historically cannot last for very long.

Similar thing for the P/E ratio. The normal inverse relationship it has with the S&P has been broken since March 11-again something that cannot last for very long.