Weekly Market Digest: 2.12.2010

As I mentioned in my Upcoming Changes article last week, I will no longer be authoring the daily market analysis column. Instead, I will be posting a once weekly update discussing longer term market trends. I will introduce a few new concepts in these posts including cycle analysis, Dow Theory, and simple trend following trading systems. As always folks, feel free to post any comments or questions using the form below.

Beginning with some discussion of cycle analysis. I often avoid applying time cycle analysis on very short-term charts, because in my opinion the whipsaw action diminishes any edge this type of study provides. However, when  this theory is applied on a longer time frame, where trade signals are far less frequent, we can gain some valuable insight.

To illustrate this, I will present a long term daily chart of the S&P 500 highlighting an approximately 85 day cycle appearing in the market (blue), and the accompanied half cycle (red).

Once we were able to identify the existence of this cycle, following the July 2009 bottom, we were able to project it forward and identify a number of key turning points in the market. The first moment came in mid-September at the half cycle bottom, when S&P prices traded around the 1050 level. From this point until early November, although during the period prices reached a high of 1100, they ultimately ended right where they started as the next major cycle bottom occurred (third blue line).

The following half-cycle bottom occured on January 19th, the exact day in which the market reached the prior intermediate high. Prices have been steadily declining since that point, and we are about halfway from the next major cycle bottom in early March. Although we do not base our trading decisions solely on the existence or theory that this cycle is actually present in the market, it is a piece of our analysis that is factored into our final outlook. When January 19th rolled around, we were very much aware that this was a potential key cycle turning point, thus we were prepared to short on any major signs of weakness.

Leading up to that session, the stock market had already accumulated three distribution days, a very bearish sign. So it was the existence of actual weakness that objectively supported our theory of an upcoming turning point, and led us to freely lay on short positions near the market peak.

 

 

One of the most widely known, time tested methods of gauging the primary trend of the stock market is the application of Dow Theory. Some of the key details that we are looking for in our comparison of the Dow Jones Industrial Average, and the Dow Transports include price divergences, and the alternating series of peaks and troughs in prices.

Below, I have circled the three key troughs on the DJIA/Transports since the March bottom. As of this writing, there are no substantially bearish signals to be seen based on Dow Theory. There are no major price divergences, as both indices simultaneously printed new highs January. Also, both indices have yet to violate the support area from their prior intermediate lows, so the sequence of higher highs and higher lows is unbroken.

 

 

For index charts, we will be following the Dow, S&P 500, and the NASDAQ. All three charts are weekly time frame, and utilize a few indicators such as EMA's, MACDH, RSI, and ADX.

First, we lets take a moment to put the big picture together. Our time cycle analysis says we should be looking for a potential bottom in late March, and our Dow Theory chart says that our primary bull trend is likely still active. We also know that an average stock market correction typically lasts between 4-8 weeks. According to the charts, we have been in a correction for about 4 weeks, so our projection of a bottom in late March looks feasible right now. Thus we are not going to blindly start buying in late March, but if we see legitimate signs of accumulation and short-term bullish reversal signals, we will be ready to deploy capital. If these signals flash,  we should have the opportunity to take advantage of a tradable upside move.

EMA

On all three indices, prices are holding above long term EMA support (40 week), a sign that the bulls still have control of the primary trend.

RSI

Another factor that favors the bulls' case, RSI has turned higher after pulling back towards the 50 level. Notice that in bull markets, RSI frequently reaches or approaches overbought levels (70) when prices rally, and, when prices pull back, the RSI typically holds the 50 level, rarely hitting an oversold (30) reading.

This contrasts with how the RSI behaves in bear markets. When prices rally, the RSI seldom reaches above 50 (a sign of weakness), and when prices decline, the RSI frequently dips into or close to oversold territory.

MACDH

On the MACDH, we are monitoring the slope between the current and prior bar, and the relative location as well. Currently, the MACDH is trending to the downside, and is trending below the zero line...what does this tell us? As long as the MACDH is sloped to the downside and below the zero line, we will not be buying stocks. However, we are acutely aware than once the MACDH does tick to the upside and reverses its current direction, a new intermediate uptrend may be ready to blossom. For now, we must be patient and wait for our indicators to signal a new bullish uptrend.

ADX

A declining ADX (black line) signals a breakdown or reversal of the prior trend (in this case upside). Also, the relative positioning of the +DI and -DI lines tells us a bit more about which side of the market is dominating the underlying trend.

According to the charts, the ADX line has been slowly rising since July/August, with the +DI (green) line above the -DI (red) line. This signals a clear bullish trend. However, in early January, the picture changed as the ADX line reversed to the downside, and the -DI line crossed above the +DI line. This signaled a breakdown of the uptrend, and warned that the bears may be gaining control of prices.

Until we see the +DI line resume its prior position, a signal that the bulls have regained control of the underlying trend, we will avoid buying stocks and let this correction play out.

 

 

 

Last up is a long term look at the U.S. Dollar Index featuring 10/20/40 week EMA's. This chart does a good job of showing the application of a very simple EMA crossover system. This method uses 10/40 week EMA cross-overs and cross-unders for trade signals. When the 10 week EMA crosses above the 40 week EMA, it signals that the bulls have taken control back from the bears, and it is time to buy. We do not exit our position until a sell signal triggers, only occurring when the 10 week EMA subsequently cross back under the 40 week EMA. Although primitive, this system has worked well since 2005 and kept one positioned on the right side of the market trade for a majority of the trend.

The recent rally in the Dollar that began early in October has advanced nearly five points, over a multi-month period. As a result of this price reversal, we have recently just flashed a crossover buy signal for the Dollar. Prices are just below the 2005 support/resistance level, so it may be best to wait for a confirmed price breakout, but the EMA signal is clear.

Now there is a caveat behind all of this. This type of system works well in trending markets, but can lead to many false/whipsaw signals when the market stops trending. It is still important to use sound risk management so one is prepared to handle this potential scenario, and this can be accomplished through the use of stop loss orders.

 

 

 

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