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Sector Watch: Mr. Market Meets Mr. Bear… What This Reliable Indicator Reveals About The Next Move
Monday, July 14, 2008
by Jim Stanton, Technical & Quantitative Analyst, Smart Profits Report
I hope you like bears… because Wall Street has just officially snagged a big one.
Last week’s volatile stock market action sent the S&P 500 into what economists officially call bear market territory, having fallen 20% from its 2007 high. It joins the Dow Industrials, Nasdaq Composite, NYSE Composite, and S&P 100 in “bear ground” and in making new lows for the year.
With the market still under heavy pressure from record oil prices, the financial sector fallout, and now the failure of massive mortgage brokers Fannie Mae and Freddie Mac, it feels like the bears are in complete control.
It was the fourth straight weekly decline for the Dow and the sixth consecutive weekly decline for the S&P 500 and the Nasdaq.
However, while the Dow and S&P 500 had weekly declines of around 1.75%, the Nasdaq was only down 0.3% and the smaller-cap indexes (Russell 2000, S&P Mid-Cap, and S&P Small-Cap) actually closed higher for the week.
The biggest surprise last week was the Dow Transports, which gained close to 100 points.
So far, the Dow Transports, Nasdaq and smaller-cap indexes have managed to stay above their lows from earlier this year.
But hey, there is a glimmer of hope…
A Silver Lining… Albeit A Thin One
Let me preface this by reminding you that markets can stay oversold longer than expected.
However, as long as there are no new surprises in the financial sector and the oil market calms down from its frantic up and down action of last week, we should see a rally begin sooner rather than later.
That’s because on an intermediate-term basis, the indexes are pushing into oversold territory. Based on the action in the Dow Transports, Nasdaq, and smaller-cap indexes last week, they look ready for at least a technical rally in order to work off the oversold conditions.
That’s the intermediate-term. Longer-term, however, the jury is still out. As I noted at the top, all three major stock indexes have descended into bear market territory.
As of this morning, the Dow Industrial Average is down 21.6% from its record closing high of 14,164.53 in October.
The S&P 500 is down 20.8% and the Nasdaq is off 21.7%.
A Long-Term Lag
Quite frankly, I don’t put much stock in the 20% bear market theory - I prefer to read the charts, rather than adhere to any official bear market tags.
And both the daily and weekly charts show me that the correction may have further to go over the longer-term. The Dow and S&P 100 did reach their minimum downside targets last week, but the S&P 500 and the NYSE Composite should have gone lower to set up an ideal reversal point.
The most bullish scenario would be a high volume, panic selloff with a very high $VIX (volatility index) and put/call readings. This would clear out all the sellers and set the market up for a sustainable rally.
This is still a possibility over the next week or two, but if the markets rally prior to that happening, and the volume and advance decline readings are unimpressive, we can probably expect more selling once the rally runs out of steam.
Let’s take a look at two of the most crucial indexes…
Dow Theory Revisited
Aside from a few exceptions (mostly commodity-related), most of the ETFs and sector charts look very similar, so let’s take another look at what “Dow Theory” is telling us over the longer-term.
If you’re not familiar with the Dow Theory, it simply states that the Dow Industrials and Dow Transports must move in unison in order for a trend to continue. If one makes a new high or new low, which is not confirmed by the other, it sets them up for a reversal.
And who said technical analysis was complicated?!
If you want to read about the concept in more detail, just take a look at a couple of my previous columns - one in this “Sector Watch” on May 19 and another one here.
The Theory In Action… How The Sell Signals Worked
Take a look at those red asterisks on the charts. Just like at a traffic light, they indicate a stopping point for the indexes - that is, a non-confirmation by one of them. In turn, this led to Dow Theory sell signals.
In addition, the Transports made a token new high on May 19, but reversed immediately, setting up another Dow Theory sell signal.
On the other hand, the lows (marked in blue) occurred at the same time, meaning that it was a confirmation that the downtrend was still intact.
As you can see, both of these sell signals worked, as the Dow Industrials failed to make new highs and the index is sitting at new lows for the year.
However, in order for the Dow Transports to confirm these new lows, it would have to drop another 700 points! Not impossible, but a very tall order.
So if that doesn’t confirm a low, does it mean a buy signal? Not quite…
Setting Up The Buy Signal
While that 700-point margin does not constitute a Dow Theory buy signal, it does tell us that the indexes are set up to trigger one. With that 700-point cushion, the Dow Transports could still fall quite a bit and still be set up for a Dow Theory buy signal.
In order to trigger a Dow Theory buy signal, the Dow Industrials would have to trigger a daily buy signal and although it’s set up for one since it reached its minimum downside target, it’s too early to tell where that would occur.
If these indexes rally from here, a Dow Theory buy signal is possible but at this point, the odds are against it. As I mentioned above, a sharp panic selloff would set up a much better situation for the indexes to make a meaningful low - especially if the Nasdaq, smaller-cap and, of course, the Dow Transports don’t make new lows for the year.
That’s all for this time.
Jim Stanton
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