Action-Reaction

By Frank Barbera CMT. June 23, 2009

Understanding, absorbing, and processing the lessons of “markets past” is often one of the key ingredients in putting together a winning investment program and forging a successful investor. While no two economic climates are ever the same, and no two stock markets are ever the same, successful investors tend to have an established historical knowledge that can be employed to help assess complex situations. While history may not repeat precisely, on many occasions, it rhymes.

In my view, markets behave much more akin to ‘living breathing’ organisms, then some random pattern of up and down movements as the ‘Ivory Tower’ types would have unweary investors believe. ‘Inhaling-Exhaling’, ‘Inhaling-Exhaling’, -- markets act as the grand social mirror, reflecting mass psychology in motion. It’s as if societies collective consciousness wakes up each and every day, and over time transitions from a good mood to a bad mood and back again. As we can seen in the chart below, the NASDAQ Composite was in a very good mood for most of April and May, but has re-awoken over the last few days in a more foul tempered, agitated frame of mind. In studying the broad mass of NASDAQ stocks, we observe that the McClellan Summation Index had soared to ultra overbought values, and over the last few weeks, had begun to trail off despite a series of higher highs in the NASDAQ Comp.

In the parlance of technical analysis, the Summation Index has traced out a bearish divergence against price, and in a more exact parlance, a ‘failure swing.’ The ‘failure swing’ occurs when the indicator reaches a major high, declines off that high, then rallies up to a lower high, and then reverses down to a set of fresh lower lows. Once the indicator moves below the initial reaction low having recorded a failing (lower high), a failure swing is in place. Usually as prices reverse to new lows prices start to decline in more obvious fashion, with an attendant negative ‘mood swing’ empowering the decline. That happened on Monday as the World Bank cut its estimate for global growth.

Above: NASDAQ 5,000 then BUST, a failing pattern on the Summation Index warned of a possible crash in Tech stocks back in March 2000.

In addition to the internal weakness in breadth, volume as measured by NASDAQ Money Flow has also been much more lethargic over the last few weeks. In the next chart we see the NASDAQ Composite on the top clip, with NASDAQ Cumulative Money Flow on the bottom clip.

While prices continued to surge to new higher highs in late May and early June, NASDAQ Money Flow lagged badly and barely managed to score a token new high. Again, this kind of bearish divergence is usually a strong indication that a material correction lies ahead. So with prices now beginning to sell off, the question of the day becomes, what can we expect in the way of a price decline, and/or percentage set back. To answer this question, history can perhaps be a useful guide. With this in mind, let’s take a stroll down memory lane to see what happened following some of the larger market rallies of the last 100 years.

SPX Low	SPX High	% Gain	Time Duration
3/23/2001	5/25/2001
1081.19	1315.93	21.71%	8.5 weeks
9/21/2001	1/4/2002
944.75	1176.55	24.53%	15 weeks
7/26/2002	8/22/2002
775.68	960.87	23.87%	5 weeks
11/21/2008	1/2/2009
741.02	934.73	26.14%	7 weeks
3/21/2008	5/23/2008
1256.98	1440.24	14.57%	9.5 weeks

To be useful, we need to look at those large advances that came on the heels of a major bear market decline, and were compacted into a relatively small period of time. In addition, to be conservative, we need to focus on those instances when the advance was not the start of a new bull market. Now in using these admittedly subjective guidelines, we are not ruling out the possibility that the current advance could be the start of a new bull market, although in my view, that does seem to be a more remote circumstance. Instead, we are operating on the assumption that either the recent rally was (a) the entire bear market rally and will be followed by new lows ‘down the line’ or (b) that the recent rally was a portion of a larger bear market rally that following a correction could still have more room to run.

Above: The 1938 DJIA Bear Market Rally rallied over 40% in the 16 weeks coming off the low.

In all of the prior stock market history going back the last 100 years, the ‘best-fit’ analog to a ‘non-new bull market scenario’ was the market rally of 1938 which followed the dire 1937 collapse. While the table above shows some of the recent bear market rallies from 2000-2002, and even 2007/2008, none of these compared well in amplitude to the recent market experience. Instead back in 1938, the DJIA bottomed on March 3, 1938 at a reading of 97.46, and then rallied for 16 weeks up to a high of 144.91 on July 25, 1938. This was an advance of 48.69% in 16 weeks. That compares quite closely to the recent S&P gain of 43.40% in the 14 weeks spanning the March 6th low at 666.79 to the recent June 12th peak at 956.23. Using the 1938 price action as a guide, the high of July 1938 produced a 9-week correction that saw the DJIA decline by 10.76% to a low value of 129.31 the week ended September 26, 1938. This downside correction was then followed by a second sharp advance which recorded a peak at 158.41 on November 14, 1938 (seven weeks duration), and a near double top peak on December 31, 1938 (14 weeks duration) at 154.76.

Using the same figures to today's situation, a 10.76% decline off the recent S&P peak at 956.23 would yield a retracement down to 853.33 with a low due in by the week ended Friday, August 14th. This could then be followed by a rally to a peak near 1040.46 lasting approximately 10 weeks for a peak in late October (10/23/09) 2009. Of course, no historical analogy is ever exact, but at least in the case of 1938 some of the background technical and fundamental factors seem quite similar in both time and amplitude.

Yet another very rough analog can be found in the past historical action of the Japanese stock market as tracked by the Nikkei 225. Back in August 1992, the Nikkei recorded a low of 14,194.30 and then rallied in explosive fashion for four weeks surging to a peak at 19,273.00 for a gain of 35.78% (see point (A) in the chart above) in just 4 weeks.

Above: the Nikkei 225 1992-1995

This was then followed by a nasty 10 week decline which saw the Nikkei decline by 15.78% pulling back to a low of 16,011.20 on November 20, 1992. In the end, the Nikkei retraced almost exactly 60% of the initial advance but was able to form a higher low and ultimately, began a second bear market rally advance (see high a Point (C)). In the current stock market, a 15.78% decline in prices would move the S&P 500 down to a low of 805.33 with a 10 week decline projecting a low in late August. Of course, these outcomes assume that the recent 40%+ rise in the S&P and NASDAQ is part of an ongoing bear market rally. While this may be the case, there have been two other notable instances where very compact 40% rallies, (rallies that were contained within a period of 10-20 weeks) represented the entire bear market rally. The first was the great failing rally of November 1929 to April 1930 following the 1929 stock market crash, and another more recent example was seen in Hong Kong in the 1997 Asia Crisis. In both cases, the market staged what looked like a very compelling come back and then gradually, and persistently began to roll over, eventually wiping away all of the prior gains.

Above: DJIA post the 1929 Crash had a major advance, but ended up giving back all the gains and moving down for the next few years.

Above: the Hang Seng Index in the 1997-1998 Asia Crisis also staged an impressive 40% rally (Point A to Point B) but also eventually gave back all the gains.

As a result, both traders and investors are going to need to remain flexible with regard to the markets potential primary trend. In my view a 10 to 15% retracement would seem to be fairly normal, but a dip much beyond that would start to argue that perhaps the primary bear is once again taking control. In believe if a forthcoming correction takes on a ‘slower paced’ tone, meandering back and forth and gradually easing its way down toward support, that would be a very encouraging sign. This type of development would be characterized by a number of minor rallies and declines, perhaps saw toothing its way gradually lower into the late July–August time period. For the S&P, the 848 to 850 zone is good initial support, with the 825 to 830 zone
even more important support.

If in the weeks ahead the S&P moves rapidly down toward the 825 to 830 zone, and then starts testing the 795 area, which is the full 50% retracement without much of an intervening rally, we would start getting nervous that the great bear market decline could be reasserting itself.

Another technique that can be helpful in this type of circumstance is the so-called Speed Resistance Trendlines originally developed by the late Edson Gould. In his ‘speed-resistance’ theory, if prices break below the rising 1/3 speed resistance line, it suggests that they will test the rising 50% line. If in turn prices break below the rising 50% trendline, they will then test the rising 2/3 speed resistance line. If prices test and break the rising 2/3 speed resistance line, it means the entire rally will be retraced and in all likelihood new lows lie ahead. As can be seen in the chart above, in the weeks ahead the lower rising 2/3 speed line will be at values of 773 by early July, 805 by early August, 819 by mid August and 837 by late August. Thus, I come back to my prior point, the slower paced any correction is, the more time it allows for the lower 2/3 speed line to rise, giving investors an earlier price warning in the event that prices are unable to find support. For now, we are in the correction camp, and believe that the 825 to 850 zone stands a good chance at supporting the stock market in the months ahead.

That’s all for now,

Frank Barbera

© 2009 Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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