Throw Away the Cookbook and Focus on the Big Picture
“There's No Magic Formula”
by Martin Goldberg CMT. October 6, 2004
The latest sharp and bullish "V" shaped correction against the apparent primary downtrend has motivated negative emotions in many market observers because of the excessive valuations and speculative stocks once again leading the market upward. It is times like these where it is best to keep your wits about you and follow a logical strategy, but of course this isn't easy. We're seeing levels of speculation that are actually like those of late '99 early '00. Although my stake in the market is only that of my family and friends, emotions may run deeper for professional money managers who rely on their stock market judgment for their living. As I pen this on Sunday night, it’s the sheep that are the smart animals once again in this stock market and there seems to be many breeds of sheep out there. My "standing" on FSO such as it is, has given me both the privilege and the pain of discussing the market with many professionals, and I feel their pain to some extent. Seems that the best of them have integrity and deal with the stock market as an independent thinker and without rigidity or emotion. Now's not the time to disagree with the market, but it is also not the time for blind use of inflexible formulas, or finding excuses why the stock market is "wrong." Accordingly, if Dow Theory flashes a technical "buy" you may want to consider whether you want to hop aboard large and long stock market positions using a method that would have had you missing the first 47% of an upturn in the S&P 500 index, while buying at just the time when business fundamentals suggest that by all historic standards, the market is due for a severe fall. It is better to consider the entire technical picture of the stock market before acting on such a mechanical buy signal.
The stock market is an organic thing, and the blind use of rigid models may not be successful for reasons that go back to the basis of most technical analysis. That basis is that the purpose of technical analysis is not to be right all of the time. It is to provide good investment/speculation results by managing risk and trying to put the odds in your favor over an extended period of time. In short, it’s to make your wins more frequent and larger than your losses. That brings up the need for investors to avoid making one big decision. If the one big decision is wrong, then the results will be faulty (even disastrous) and very damaging to your financial well being. If you are out of the stock market and the Dow theory flashes you a "buy," good luck with it, but I probably won't be joining you in all likelihood. (At least not in a big way.) Hopping into the stock market in a big way based on such a mechanical "buy" without thoroughly examining the entire technical and fundamental picture is too risky because losses can mount if the sell signal is as slow as the buy signal may be.
In addition, being long provides no protection against a stock market crash. This aspect should not be underrated in spite of most public and professional opinion suggesting some form of organized support is protecting our stock market and therefore a crash cannot occur. I'd rather look at the broader market with an eye toward fundamentals and valuations as well as viewing the entire technical picture. From that standpoint, you would have to ask yourself whether Dow theory has ever flashed a "buy" with fundamentals and valuations so out of whack as they are now. In some important ways, today's market resembles a top more than a point in which to put out fresh new buys. In addition to that, I'm seeing many technical weaknesses in many important charts that are simple enough to suggest there is a lot of risk in this speculative stock market. If ultimately not following the "buy" signal results in significant gains missed, that's alright because if you are going to miss the first 47% of a bullish move, then you may as well miss the entire move. It's best to chalk the miss up to experience and go on from there. In my view, while properly applied technical analysis can help you to make money in the stock market while limiting risk, there is not a cookbook to making money in the stock market. Tonight, I will illustrate some of the weaknesses in the technical charts that suggest the intermediate prognosis of the stock market does not appear to be bullish.
The Retail Index is showing a Broadening Pattern
It is a simple principle that a sustainable bull market includes higher lows and higher highs. I've discussed the broadening pattern several times after the apparent January 2004 stock market top as a sign of weakness. The 5-point broadening patterns were prevalent in the 1929 stock market top, and since then have occurred only rarely until this year. In 2004 this market-topping pattern has given us the 7-point broadening pattern. In my view this speaks to the high level of speculation that is occurring in today's stock market as I discussed previously. In addition, as was stated in "Technical Analysis of Stock Trends" by Edwards and Magee, this pattern is ultimately bearish. There is reason to believe that these patterns that formed in 1929 also will end in a similar ugly manner. Following is a chart of the S&P Retail Index.
You don't have to go to the mountaintop and study with the sphinx of technical analysis knowledge to see that this is a wild technical pattern that is more reminiscent of a top than the beginning of a new bull run. Note lower lows and higher highs – a broadening pattern. Could something change my mind about the bearish implications of this pattern? If the upward sloping trendline of higher highs were to be decisively broken to the upside, I would have to rethink my view. Here is a longer-term view of the Dow Jones Retail index.
The Dow Retail index has different components as that of the S&P retail index, yet you can see retail has been a "pendulum" over the last 5 years. After the gift of free money from the government, the retail stocks have swung to the high point of their pendulum. With the Dow Retail index showing technical weakness (lower highs, and lower lows and a rounded top), while the S&P index is making a 7-point broadening pattern, the technical picture appears bearish for one of the leaders of the stock market – retail. Finally, one of the leaders of the last market rally – The Gap (GPS) – is showing obvious technical weakness as illustrated in the chart below.
A decisive break of the support level at about 17.5 would be damaging for the Gap and would indicate a possible support to about 13 based on the head and shoulders measurement principle.
In Spite of Wonder Rallies, the Nasdaq Looks Weak
The charts below depict technical characteristics that suggest that the intermediate and long-term trend of the Nasdaq are still down. I do not wish to depict these observations as the "holy grail" of technical analysis, but only to show that we are dealing with actual technical weakness that deserves attention if not immediate action. Coupled with the fundamental case of excessive valuations and negligible dividends suggests that it would not be a good idea to "plunge in" because of a mechanical method buying signal. I focused on the Nasdaq index because this is a major driving force in the highly speculative market. The chart below depicts the intermediate term Nasdaq in the form of a 2-year weekly candlestick chart that includes Chalkin Money Flow and the 26-week simple moving average. Note that since the January of '04 top, there have been 22 weeks where the Nasdaq finished lower and only 15 "Up" weeks. "Down" weeks that had above-average trading volume where more frequent than "Up" weeks. There were 9 such "Down" weeks and only 5 such "Up" weeks. Thirteen-week Chalkin money flow is negative, and this has been a useful indicator over the last 3 years.
Below is a monthly candlestick chart of the Nasdaq index dating back to 1996.
As can be seen in the chart above, slow stochastic analysis offered accurate and timely buy and sell signals over the last 4 years. There was a sell signal 4 months ago. Chalkin money flow (9 month) would have also produced timely signals if you had waited until it moved above or below the zero line. It has yet to signal a "sell," yet the pattern of lower highs in positive territory suggests an "alert" for the "sell" if and when the Chalkin money flow moves below the zero line. Note that as indicated in the price by volume chart along the left-hand axis of the chart, that a lot of "work" has been done between 1200 and 2000 on the Nasdaq. This area has proven to be one of strong resistance for penetrating from the downside. A decisive break into new high ground above the gray line would be bullish. Yet I don't mean to sound like a broken record in saying that I find it very difficult to believe that the Nasdaq market can climb the same bubble ladder that it climbed in what is arguably the biggest bubble of all time. Still the market is to be respected. On the downside, there is very little meaningful support between a decisive break down at 1750 to 1500 as seen in the 3-year weekly chart above.
S&P 500 Equal Weight – At the Crossroads
The S&P equal weight index is nearing a high at about 1440, which it reached 4 times and failed to break to the upside. Each time it failed it went on to make a lower low resulting in a broadening pattern. Technically it would appear unlikely that the S&P equal weight could make a significant surge beyond its high without taking a rest after the sharp and radical "V" shaped recovery from 1300.
The examples cited above are many of the irregular and generally unhealthy speculative patterns that tend to occur at market tops more so than at bottoms. References to such patterns can be found in Technical Analysis of Stock Trends, 8th Edition by Edwards and Magee, originally written in 1947, and a previous Market Wrap Up article. In summary, my message is that there are many aspects of the technical picture of the stock market that suggest that a mechanical buy signal should be viewed with a healthy dose of skepticism.
For Fun Only – A Prediction – When and What Will Happen When Dow Theory Says "Buy"
I'm guessing that some supermarket-sold monthly magazines are presently considering cover stories on Dow Theory for their November '04 issues. On Friday, October 29th 2004, at about 1pm New York time, the Dow Theory will flash a "buy" signal when the Dow Jones Industrial Average moves to a new 52-week high. That Friday the Dow will rise 350 points and the Nasdaq will put in its first triple digit rise since February of 2000. The "buy" signal will be embraced by most bulls and (former) bears alike, all parading on TV one after another to tell and sell the public on the positive stock market implications of the "Buy signal." For the first time in years both "perma-bulls" and legions of Dow Theorists will be thinking and selling the same thing to anyone who will listen – "BUY"! CNBC will run a special on the following weekend entitled, "Dow Theory Buy Signal – What Does It Mean for Your Portfolio?" (Hosted by Sue Herrera and Larry Kudlow). It will include bullish interviews with the usual regulars in addition to the most esteemed and popular proponents of the Dow Theory, and these people will all espouse the bullish long-term implications of the signal. Of course the "Buy signal" will be a discussion topic on "Luis Rukeyser's Wall Street." The following Monday on "Morning Call" and "Squawk Box," commentators (not including Barron's Mike Santoli) will don party hats. On Monday, once again the Dow and Nasdaq will post healthy gains of 100 and 35 points respectively, as volume will swell to well above the highest trading volumes on record on all the US exchanges. On Tuesday the indices will be up by only single digit amounts and the volume will stay well above average. That Wednesday, after a positive futures market and a gap up open, the Dow and the Nasdaq will trade at the flat line or perhaps up a few points and again volume will be impressive. On Thursday, S&P futures will trade down 20 points before the open, as morning business commentators suggest its just a little correction following the early week surge. Following the open, the indices will drop as volume and intensity of the drop will accelerate throughout the day as the early market break turns into panic selling. That day will be known from then on as "Black Thursday." November 2004 popular weekly magazines with "DOW THEORY SAYS BUY" as the cover story become collectors' items. In long-term retrospect these magazines become the best performing investments of our era. Is this for-fun prediction beyond the realm of possibility? Decide for yourself.
After trading at the flat line until 3pm Eastern Time, it was time for the stock market to party as the Nasdaq chalked up a 0.8% gain between 3 and the 4 O'clock close. Each index was up by about that amount except for the Dow, which once again lagged because of Merck. The Nasdaq has now logged 7 straight up days and it almost makes me wonder whether it will ever have another down day. Yet, I have seen and referenced pre-1990's market studies by Victor Sparendeo such as those in Trader Vic, Methods of a Wall Street Master, suggesting in a secondary correction against the primary trend, when an index chalks-up more than a four day streak, the first day the streak is broken represents the end of the correction. Yet, this 10 plus year old signal failed during the Ganymede rally, which ended in January of 2004. The underlying principle of his signal, that rallies against the primary get overheated when they chalk-up a final dumb-money winning streak, may still have some relevance though. Yet we could be looking at a new primary bull trend as well. If you believe that, you would have to believe that this could occur immediately after an extremely large bubble, arguably the largest in the history of the US stock market. You would have to believe that this new bull could occur with dividend yields near historic lows. You would have to believe that this could occur, after the S&P achieved all time high earnings, yet is showing an actual reduction in shareholder equity this year versus last year (Oct. to Oct.). Yes, it’s been a very "special" year, or you could call it a "one-time event."
The stock market has not noticed that there have been a couple of cockroaches let out of the housing/mortgage arena. Pulte homes had to lower their prices in Las Vegas. Yet after an initial sell off, the housing stocks recovered nicely over the last 2 days. The market is seeing the Pulte news as "just an aberration," nothing to get excited about. The 10-year note price has broken an intermediate term trendline to the downside. And any betting person may believe from the action of the stock market itself that the upcoming jobs and economic numbers will be good. So any sane person would think that this good news is hurting bonds and so mortgage rates will probably go up. Now if pricing power in homes has been overstated by at least one homebuilder in one area of the US, what will higher mortgage rates do? Was the Pulte/Vegas thing an aberration? I don't think so. Here is the chart of the 10-year note. Note the broken trendline. If interest rates go up, then the shaky "fed model" for stock valuations falls apart. No matter for most Internet stocks though since they are selling only a happy story.
Following is a weekly chart of the DJ US Homebuilders index. Note the bearish implications in the formation of the head and shoulders reversal pattern (not yet completed). Note the unimpressive volume on the rally that made the suspected right shoulder. Bonds, Fannie Mae, and the US home construction index are all looking technically bearish.
Gold was down $0.90 at $417.80 silver up $0.15 at $7.22 per ounce. The US Dollar index was up 0.24 at 88.45.
Finally, I'm hearing such buzz in the media about how it’s not fundamentals that are driving the price of oil as much as "the speculators." Yet Google closed the day at $137 per share, without a single word in the media at any time about "the speculators." Amazing!
Have a great evening!
© 2004 Martin Goldberg